California’s S.B. 185, thermal coal, and the fallacies of social investing

Recently signed into law by California Governor Edmund G. (Jerry) Brown, Jr., S.B. 185 requires public employee pension plans to divest their investments in publicly-traded companies that derive half or more of their revenue from “the mining of thermal coal.” California’s law is the most recent manifestation of the campaign for social investing by states’ employee pensions. The advocates of social investing seek to use pension funds to pursue policy objectives extraneous to the financing of employees’ pensions.

As one who shares the environmental concerns evidently animating S.B. 185, I would commend California if it adopted a revenue-neutral carbon tax. However, the social investing mandated by S.B. 185 is a misguided way to pursue environmental or other worthwhile goals. Social investing by pensions is both wrong as a matter of law and ineffective as a matter of policy.

An individual can invest her own money to pursue any environmental or other social goals she favors. However, as a legal and practical matter, pension funds are different. Such funds are, as the old saying goes, other people’s money. California’s pension funds represent deferred wages owed to government employees, financed by taxpayers to underwrite the retirement benefits promised to these employees. As a matter of law, such pension funds are to be invested in accordance with the highest fiduciary standards, exclusively to finance retirement benefits. Pension trustees’ only concern should be providing such benefits, not pursuing extraneous goals, however noble such goals may be.

California’s constitution explicitly adopts the traditional articulation of this high fiduciary standard for the public employee pension funds of the Golden State:

The assets of a public pension or retirement system are trust funds and shall be held for the exclusive purposes of providing benefits to participants in the pension or retirement system and their beneficiaries and defraying reasonable expenses of administering the system.

This traditional standard, often labeled as “the exclusive benefit rule,” reflects the hard-won lesson that monies held by trustees in general and by pension trustees in particular can be diverted from their mission—namely, the provision of the benefits promised to beneficiaries. Once the door is opened to extraneous considerations in the investment of trust funds, that door is not easily shut. More likely, the door will stay open for pension resources to be used for more collateral causes rather than the provision of retirement benefits. Sometimes these causes will be admirable; sometimes they will not.

Hence, as a matter of case law, statutory law and, often, state constitutional law, pension trustees are held to the highest fiduciary standard; their investment of pension assets should serve “the exclusive purpose of providing benefits to participants.” When public pension funds are instead used to punish coal mining companies or to pursue any other social objective, such funds are not being used exclusively to provide retirement benefits.

Who is to decide what is an appropriate social objective to pursue with public pension monies? Suppose that legislator X favors divestment of the stock of any medical equipment manufacturer whose products can be used to perform abortions. In contrast, legislator Y wants to sell the stock of any company whose management is insufficiently pro-choice.

The traditional fiduciary standard embedded in California’s constitution is intended to prevent pension funds from becoming political battlegrounds of this sort. Under this high standard, pension trustees are to ignore political and social policy objectives and instead concentrate exclusively on the financial objective of providing retirement benefits.

In practice, social investing is ineffectual. If California’s pensions sell the stock of a corporation which derives half or more of its revenue from mining “thermal coal,” someone else will buy this stock. The resulting game of musical chairs merely shuffles the identity of the corporation’s shareholders.

The details of S.B. 185 further confirm that that law is a legal and practical muddle. S.B. 185 permits California’s public employee pension plans to retain without limit the stock of companies which derive revenue from mining nonthermal coal, for example, corporations which sell coal used in manufacturing. Why is coal burning acceptable for some purposes but not others?

Equally troubling is the 50% rule of S.B. 185. If a relatively small company derives all of its revenue from mining thermal coal, S.B. 185 requires that the stock of the company be sold. However, a huge conglomerate may sell vastly more coal than this small company but not trigger divestment under S.B. 185 because its coal sales constitute less than half of this conglomerate’s revenues.

Particularly anomalous is S.B. 185’s qualification that pension trustees should not divest the stock of coal companies unless such divestment satisfies the trustees’ fiduciary obligation to exclusively fund pension benefits. If selling the stock of a coal (or any other) company furthers the financing of pension benefits, that sale need not be legislated since the trustees should make that sale anyway. If it is necessary to prod California’s pension trustees on social investing grounds to make that sale, this is prima facia evidence that the sale should not be undertaken. By definition, the sale of the stock of a thermal coal company to advance environmental considerations is not made “for the exclusive purposes of providing benefits to participants in the pension or retirement system” as California’s constitution requires.

The environmental concern underlying S.B. 185 is compelling. However, the social investing required by S.B. 185 is misguided. Such social investing dilutes the high fiduciary standard under which public pension funds are to be invested exclusively to finance retirement benefits.

Image Credit: “Coal Excavator” by Dren Pozhegu. CC BY NC 2.0 via Flickr.