On January 10, 2025, Judge Reed O’Connor of the Northern District of Texas issued a much-anticipated ruling in Spence v. American Airlines, Inc., which marks the first time that a federal judge has written an on-the-merits decision on the controversial topic of ESG and the duties of retirement plan fiduciaries under ERISA. In his opinion, Judge O’Connor found that American Airlines and the American Airlines Employee Benefits Committee (“EBC”)1 breached their ERISA duty of loyalty by including funds on the American Airlines 401(k) Plan2 lineup that were not ESG-focused funds but were managed by a non-party investment manager (“Investment Manager”) that the judge determined to have engaged with issuer companies on ESG-related issues and on occasion voted proxies in support of ESG-related proposals. At the same time however, the judge did not find a breach of the duty of prudence under ERISA, because the defendants’ monitoring practices with respect to the Investment Manager were in line with the prevailing standards among other large plan fiduciaries.
While the news headlines suggest that the case is about ESG investing, none of the funds on the Plan menu were actually ESG funds. The ruling is solely focused on the Investment Manager’s proxy voting practices and alleged pro-ESG shareholder engagement. From that perspective, the case can be viewed as another battle in the broader crusade to derail ESG investing practices in the United States.
From a plan fiduciary standpoint, Judge O’Connor’s ruling is concerning because it deals with the nearly universal practice of delegating proxy voting authority to an ERISA plan’s external managers. For that reason, the ruling has important ramifications for all sponsors of 401(k) plans, and it should not be dismissed as only applicable to plans with investments that bear ESG attributes. This decision, especially if its reasoning is upheld on appeal and adopted by other courts, could cause ERISA plan fiduciaries to consider changes to their longstanding practice of delegating proxy voting to their investment managers which could potentially include: (i) implementing certification/attestation protocols with respect to voting, (ii) conducting more robust due diligence of managers’ voting records prior to selection or (iii) assessing the possible use of pass-through voting, where votes are passed on to the participants and beneficiaries directly.
Background
In June 2023, the plaintiff, who is a pilot and participant in the Plan, filed a putative class action lawsuit against American Airlines and the EBC asserting that the defendants mismanaged the Plan and violated their ERISA duties of prudence and loyalty as a result of using investment managers who pursued supposedly “non-financial and nonpecuniary ESG policy goals via proxy voting and shareholder activism.” At issue were passively managed index funds that invested exclusively in a collective investment trust overseen by the Investment Manager3 (although the plaintiff’s theory of liability could potentially apply to registered funds on a plan lineup). The plaintiff claimed that the Investment Manager harmed the financial interests of plan participants and their beneficiaries because it pursued a “pervasive ESG agenda” and this “engagement strategy…covertly convert[ed] the Plan’s core index portfolios to ESG funds.” According to the plaintiff, the defendants gave Plan assets to the Investment Manager who purposefully pursued ESG activism (in the form of public statements by the Investment Manager’s CEO regarding the risk of climate change as well as the Investment Manager’s vote in favor of an allegedly pro-ESG proposal at ExxonMobil in 2021), which allegedly caused the Plan’s holdings to underperform and lose value.
The plaintiff alleged two causes of action under ERISA: (i) breach of defendants’ fiduciary duty of prudence by choosing to invest Plan assets with an investment manager that embraced ESG objectives and failing to monitor or stop the Investment Manager from pursuing objectives that were harmful to the Plan participants’ investments; and (ii) breach of the duty of loyalty by continuing to use the Investment Manager and endorsing the Investment Manager’s alleged pro-ESG agenda to serve the defendants’ own corporate agenda and failing to act with “an eye single to the interests of the participants and beneficiaries.”
The Court’s Ruling
No Breach of the Duty of Prudence
Judge O’Connor concluded that the plaintiff failed to prove a breach of the ERISA duty of prudence in connection with the design and implementation of its processes for monitoring the Plan—in particular, with respect to selecting and retaining investment managers, overseeing proxy voting and not intervening in the ExxonMobil proxy vote. Noting how the prudence standard is objective and “inherently comparative” and that courts must evaluate the conduct in question against contemporary industry practices, the judge explained how the defendants’ procedures comport with prevailing fiduciary standards, and “at times even surpassed those typically employed by large-plan fiduciaries across various benchmarks.” When it came to evaluating investments and gauging the performance of the Plan’s managers, the opinion mentioned:
- Regular EBC Meetings to Review Plan Investment Performance – The EBC met at least quarterly to review the performance of the Plan’s investment options, and at these quarterly meetings, the EBC reviewed and considered detailed reporting regarding market developments, as well as qualitative and quantitative information regarding the aggregate performance of the Plan’s investment funds and the underlying investment managers. The EBC also prepared minutes summarizing the discussions and decisions that occurred in these quarterly meetings.
- Use of Internal and External Experts – The EBC engaged both internal and external experts to review, monitor and evaluate the Plan’s investment options and investment managers across numerous dimensions. Internally, the EBC relied on the company’s Asset Management Group to provide advice regarding the Plan, by consulting and supporting the EBC’s fiduciary function, including, with respect to the selection and monitoring of the Plan’s investment options. In particular, the Asset Management Group regularly reviewed detailed qualitative and quantitative information regarding the Plan’s investment options—specifically, performance data for investment options and their underlying managers relative to benchmarks and peer groups. The EBC also relied on an established outside consultant that was hired to provide additional investment advice and monitoring. The Asset Management Group would also regularly consult with the investment advisor to the pilots’ union, in order to collect additional feedback on the Plan.
In terms of proxy voting, the opinion noted how the Plan’s investment management agreements (“IMAs”) had delegated such activities to its managers unless specifically reserved to the EBC in a specific IMA, and that the managers were to comply with their proxy voting guidelines as disclosed to the EBC. Note, delegation like this normally applies to ERISA plan asset funds or separately managed accounts. The Plan’s managers were also responsible for providing revised voting guidelines to the Asset Management Group when updated, as well as supplying the EBC with materials regarding their proxy voting practices, including, an annual summary report of how proxies were voted in a given fund. In accordance with its IMA with the Plan, the Investment Manager was to provide quarterly attestations to the EBC confirming compliance with its proxy-voting guidelines; however, at trial, it came to light that the defendants had not received these quarterly attestations and were not able to ensure compliance with the Investment Manager’s voting guidelines. Notwithstanding the defendants’ alleged deficiencies in their oversight of the Investment Manager’s proxy voting activities, Judge O’Connor acknowledged that fiduciary committees for defined contribution plans “rarely, if ever, devote committee time or focus on independently reviewing an investment manager’s overall proxy voting practices.” Moreover, the ruling explained how historically, proxy voting issues have infrequently been judged by advisors as material to the evaluation of performance or expected performance.
In summary, because the defendants demonstrated a robust process for assessing and scrutinizing investment performance and that any perceived shortcomings with respect to monitoring the Investment Manager’s-proxy voting activities were consistent with the industry practices of fiduciaries to large plans, the court found that the defendants had not breached their duty of prudence under ERISA. This is the outcome to be expected, as courts are generally deferential to the decisions made by fiduciaries when those fiduciaries follow appropriate processes like those used by the EBC.
Breach of the Duty of Loyalty
In a surprising turn, Judge O’Connor concluded that the plaintiff had proved the defendants had violated their duty of loyalty under ERISA because American Airlines’s “incestuous relationship” with the Investment Manager and their own corporate goals disloyally influenced the defendants in their administration of the Plan. As the ruling explains, the duty of loyalty requires ERISA fiduciaries not to be influenced by the interest of any third person or by motives other than the accomplishment of the purposes of the ERISA plan. To establish a breach of this duty, a plaintiff must show that the fiduciary’s actions or decisions were primarily motivated by interests beyond those of participants and beneficiaries. According to the court, the Investment Manager had an outsized influence on the defendants, which impacted their decision-making for the Plan as evidenced by the fact that:
- the Investment Manager was the Plan’s largest manager,
- the Investment Manager was one of American Airlines’s largest shareholders (owning 5% of American Airlines’s stock), and
- the Investment Manager financed approximately $400 million of American Airlines’s corporate debt when the company was experiencing financing challenges.
The court also noted how American Airlines could have been potentially susceptible to a proxy fight (along the lines of what happened at ExxonMobil) unless it complied with the Investment Manager’s climate-related demands and reduced its fossil fuel consumption. Finally, the court cited testimony by the American Airlines’s Treasurer (and a member of the EBC) at trial that a “failure to signal that [the company] was actively complying with ESG disclosure requirements would potentially undermine its ability to obtain billions of dollars in essential loans from the [Investment Manager].” According to the court, there was a perceived value “in appeasing [the Investment Manager]” and that this “cross-pollination of interests and influence” caused the defendants to “not sufficiently monitor, evaluate and address the potential impact of the Investment Manager’s ESG-oriented proxy voting and shareholder engagement.” For example, the defendants never requested that its outside consultant analyze the Investment Manager’s proxy voting practices until after the plaintiff’s lawsuit was filed in 2023, and the members of the EBC (as well as the Asset Management Group) never raised concerns about the Investment Manager’s track record of ESG engagement during quarterly meetings.
The ruling also suggests that the lack of monitoring and oversight reflected a “shared belief” between the defendants in their corporate capacity and the Investment Manager that “ESG is a noble pursuit” and that this alignment demonstrates how the defendants did not act with an “eye single” toward maximizing the financial benefits of participants and beneficiaries. While the court focused on the alleged influence by and relationship between the Investment Manager and the defendants as the hook for the duty of loyalty breach, the ruling contained minimal discussion of any evidence that the Investment Manager’s proxy voting and engagement activities were nonpecuniary in nature. For instance, the ruling did not address the defendants’ argument that in the case of the ExxonMobil proxy vote, the Investment Manager “was motivated by its view of investors’ long-term financial interests” and the “specific concern that, unlike its peers, Exxon had failed to diversify its operations to ‘protect against a possible decline in demand for fossil fuels.” In their briefs, the defendants also explained how the Investment Manager’s vote was in line with the recommendations of the major proxy voting advisory services firms and other managers—including, Vanguard, whom the plaintiff lauded as not succumbing to the “ESG agenda pursued by other investment managers[.]” However, none of this evidence was addressed in Judge O’Connor’s opinion. Finally, the court gave minimal credence to the defendants’ argument that the retention of the Investment Manager resulted in lower fees and at least comparable returns to alternative managers during the class period.
Damages
The court deferred ruling on the question of losses pending further briefing from the parties, as well as what the remedies should be, including, whether injunctive relief is warranted and what damages, if any, are appropriate. According to the plaintiff, the Investment Manager’s May 2021 proxy vote at ExxonMobil harmed the Plan by devaluing its energy holdings, which, according to an expert who testified on behalf of the class, led the Plan to suffer short-term losses of over $15 million (the defendants have argued that the methodology for deriving that figure was “deeply flawed”). Therefore, further briefing will be necessary before the court can determine what the right amount of damages (if any) should be.
Key Takeaways
- ESG was Scrutinized even with no ESG Funds – As described above, this lawsuit did not deal with any ESG-focused, impact or similar funds. The broader net of ESG activity at issue here was based solely on the proxy activities of standard funds. In response to this decision, plan sponsors may wish to conduct greater diligence and monitoring of investment managers’ use of ESG and other collateral considerations in conducting business that impacts retirement plans. Plan sponsors and fiduciaries should also remain cognizant of the risk that virtually any service provider or investment manager retained by a plan could potentially form the basis for a similar lawsuit (although not all such suits may be successful).
- Scrutiny of Delegated Proxy Voting? – The lawsuit focused on the Investment Manager’s public statements, proxy voting activities and other instances of shareholder engagement to promote ESG objectives. This ruling (especially if its reasoning is upheld on appeal and adopted by other courts) may suggest that for ERISA plan fiduciaries that delegate proxy voting authority to their managers under the terms of their IMAs, there will be additional focus going forward on their monitoring and scrutiny of the voting activities of their managers. This could entail more robust due diligence of managers’ voting records as well as greater reliance on reporting and regular certifications/attestations that managers are complying with applicable proxy voting guidelines. Delegation of proxy voting authority is a widespread practice in the retirement industry, and it remains to be seen whether this decision will lead to enhanced monitoring of proxy voting and/or increased pressure to use pass-through voting in order to mitigate potential litigation risks for plan sponsors and plan fiduciaries going forward.
- Prudence is Process: Lessons for Surviving a Claim Alleging Breach of the Duty of Prudence – As the ruling notes, the defendants were focused on investment performance, and they had a robust process and protocols in place for doing so, which were in line with (if not exceeded) the prevailing practices of large plan fiduciaries at the time. The EBC convened regularly, they maintained detailed records and documentation of their meetings, utilized a well-regarded consultant (who was selected following a formal request for proposal process, in which the merits of Aon’s advisory services were vetted and compared to those of other investment advisory firms), and relied on various internal experts to advise them on how to evaluate the Plan’s investment options and managers. While these practices may be routine for large plan sponsors, they still provide a useful example of what measures plan fiduciaries can take to demonstrate adherence to their duties under ERISA.
- The 2022 ESG Rule Remains in Effect (for Now) – Even though the decision clearly demonstrates Judge O’Connor’s hostility toward allegedly pro-ESG initiatives and his skepticism regarding the role of ESG in investment decision-making, it does not invalidate the 2022 ESG Rule that the Biden administration adopted. That said, the rule remains subject to ongoing litigation in the same district by the attorneys general of 26 states seeking to invalidate it. Moreover, with the upcoming change in administration, the Trump-led DOL may choose to stop defending the 2022 ESG Rule, and it may also be sympathetic to the theories offered in this case as to why ESG investing and ESG shareholder engagement do not square with ERISA fiduciary duties.
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- During the class period, the EBC comprised American Airlines officers, including senior executives from different business units: (1) Treasurer, (2) Chief Financial Officer and (3) Chief People Officer.
- The American Airlines, Inc. 401(k) Plan and the American Airlines, Inc. 401(k) Plan for Pilots are the two participating plans of the Master Trust for DC Plans of American Airlines, Inc. and Affiliates (collectively, “the Plan”).
- The Plan offered four tiers of investment options to participants: (1) target date funds, (2) passively managed index funds, (3) actively managed funds and (4) a self-directed brokerage window.
Authors
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