Entering a New Decade: Will the Retail Retirement Investor Define “Material” for the SEC?

Entering a New Decade: Will the Retail Retirement Investor Define “Material” for the SEC?

We examine questions on the role of the retail retirement investor and the “impact” they can have in defining “material” to the SEC.

  • What is Socially Responsible (ESG) and Why Does the SEC Care?
  • How does a retail retirement investor measure impact?  How do they choose an ESG mutual fund?
  • How do they evaluate any recommendation from an intermediary “advisor”?

Federal securities laws are grounded in the principle of disclosure. The Securities and Exchange Commission (SEC) enforces those laws.

“The legislative debate leading up to the creation of the 1934 Securities Exchange Act underscores this focus, framing the doctrine in this way: “There cannot be honest markets without honest publicity. Manipulation and dishonest practices of the market place thrive upon mystery and secrecy.” The U.S. House of Representatives Committee Report chronicling the Act’s passage reveals congressional intent to instrumentalize disclosure not only to check illicit corporate behavior, but also to prevent even those practices that were “legal but unseemly.” (Source: Environmental Law Reporter)

There exist three levels of compliance for the SEC concerning disclosures:

(1) The SEC regulates publicly held corporations; material false statements are prohibited by securities laws (10b-5 violations)

(2) The SEC regulates SEC Registered Investment Companies (mutual funds) and Exchange Traded Funds (ETFs)

(3) The SEC regulates SEC registered advisors that act as intermediaries and sell investment product to retail investors.

With the burgeoning movement to investing in ESG Funds and ETF’s, retail retirement investor’s ESG choice must be made with “honest publicity.”

An ESG risk is deemed “material” if it has a financial impact on the company.  Those “material” issues can also vary by industry. Morningstar is using data from a firm Sustainalytics that provides company-level ESG risk ratings as a “material” basis in Morningstar’s “Sustainability” Ratings that are publicly available for mutual funds online at Yahoo Finance as one example.(4)

How Does the Retail Retirement Investor Measure Impact and Choose their ESG Investments?

How does the retail retirement investor decide where to place their retirement dollars to make an “impact?” How does one define impact? Without credible and comparable measures, impact investing may be co-opted by Wall Street’s mutual funds, ETF’s and an intermediary sales force selling such product, misleadingly labeled “ESG.”

The retail retirement investor must be provided the credible and comparable measures to make an informed choice to deter the dishonest practices that thrive in a market shrouded in “mystery and secrecy.”

The Sustainability Accounting Standards Board (SASB)  has been working on measures of “materiality” and now has 77 standards that SASB defines at their website, “Financially Material: SASB’s mission is to help businesses around the world identify, manage and report on the sustainability topics that matter most to their investors.”

“SASB standards differ by industry, enabling investors and companies to compare performance from company to company within an industry.” (1)

The SEC has Concerns with Misrepresentations to Retail Investors concerning ESG

2019 delivered significant flows by retail investors to “ESG” based on their concerns with numerous societal factors, from climate change, to a weakening of governmental regulations at the EPA to human rights abuses worldwide and within the United States’ own immigrant population. “Flows into funds focused on socially responsible investing have soared from $2.83 billion in 2015 to $17.67 billion this year through November”, according to a Morningstar report.

Yet to date, studies have shown the SEC believes the investor finds ESG factors immaterial.(2)

Retail retirement investors control over $9 trillion in assets in their IRA’s alone. They can play a critical role by ensuring the SEC is aware that climate change, human rights, and social governance in corporations are very material. They can vote with their dollars and place their retirement assets with the SEC registered investment companies, directly that they believe are materially impacting their ESG concerns.  With “honest publicity” retail retirement investors can and should choose their Funds and their portfolio managers that they believe are making material differences.

To make an informed choice, retail retirement investors can scrutinize the objectives and ESG goals of the mutual fund portfolio manager and then analyze the holdings in his or her selected portfolio. They need access to these portfolio manager objectives to make an informed ESG choice. They need the most basic online tools to analyze the Holdings in a prospectus, accompanying the portfolio’s manager’s written ESG objectives.

Those two elements are easy to accomplish in both the workplace and at the post-secondary level. Such a curriculum is significantly easier than “coding.”  Such a curriculum is the only response to the Congressional demand in 1934 for “honest publicity”.  Industry’s intermediaries in the workplace training employees on “impact”, “ESG” and what is “material” is the more certain path to possible definitions of impact that could be so easily “co-opted” by the product seller.

The SEC and the Concept of ESG Materiality

The retail retirement investor can make a significant “impact” by informing the SEC what they believe is material. The SEC is not convinced, from past rulings, that ESG disclosures are a mandatory need. The SEC is still formulating policy on what is material ESG reporting for corporations.

Recently, SEC Commissioner Hester Peirce raised concerns that an ESG focus is taking precedence over returns. “If ESG disclosures mean disclosing what is financially material, there is little controversy, but the ESG tent seems to house a shifting set of trendy issues of the day, many of which are not material to investors, even if they are the subject of popular discourse.”

Is SEC fighting what is material? As SEC Commissioner Peirce spoke last year: “Although the statement mentions “materiality” throughout, and exhorts issuers to “consider the materiality of ESG matters to their businesses” it seems that the statement envisions disclosures beyond what is traditionally viewed as “material.”

The Department of Labor’s ERISA, which oversees defined contribution retirement plans, 401(k)’s is varying their stance on whether a retirement plan fiduciary has a greater duty to returns over ESG concerns. The debate continues. Once again, the 401(k) investor can inform their employer there are SEC Registered Investment Companies (mutual funds) that are capable of achieving returns exceeding their relevant benchmark, while simultaneously honoring ESG material concerns and standards.

The SEC examiners are now questioning, how do you know if there is not a fossil fuel company in the Fund or ETF, despite an ESG label? As a recent Wall Street Journal article mentioned: “The regulator in the letter asked whether the adviser followed well-known policies for socially responsible investing, including the United Nations’ Principles for Responsible Investment. Investment firms including BlackRock Inc. and Fidelity Investments have signed onto the U.N. framework, according to the PRI, which administers the effort in partnership with the United Nations.”

Choices for Retail Retirement Investors

The primary method for IRA investors to invest in corporations is through their IRA, in addition to the 401(k) selections provided to them by their employer. Employees can urge their employers to select the available active and passive funds that meet their ESG needs and that also outperform their relevant benchmark.  One does not need 10,000 such mutual funds; one or two will do for the average retail retirement investor.

In general, IRA investors are very capable of understanding which corporations act in their best interest. Many retail investors, many “Mothers”, know the incredible difference they made when they pushed REI and Dick’s Sporting Goods to change their gun sales habits, after the Parkland shooting.

These Mothers learned how to demand which gun manufacturers were held in Vanguard and Blackrock passive index funds.  They demanded a “material” change.

Most IRA investors rely on professional portfolio managers to select their holdings. These SEC registered investment companies (mutual funds) could be active or passive. With the passive choice they are typically dependent on large assets managers, such as Blackrock, Vanguard and State Street to make their ESG alternatives. They have no opportunity to vote the proxy for these funds, since typically the brokers do the voting.

Intermediary “advisors” sell what they are trained and paid to sell. These Funds might not meet the retail investor’s ESG criteria and most often the retail investor is not trained and provided the tools to determine if such mutual fund managers meet their ESG goals.

This route and current distribution model of SEC registered investment companies to retirement investors stymies the SEC mandate that the SEC needs to know what the investor determines is “material.” The most direct way for the SEC to know what retail retirement investors believe is material and meets the retail investor’s ESG goals is to:

(1) Permit every retail retirement investor access to the online tools to analyze the disclosures provided by the ESG portfolio money manager of the Fund, particularly the written objectives and

(2) Provide the tools to analyze the holdings that the ESG portfolio manager has selected, in conjunction with a basic understanding of portfolio turnover and how to measure such through SEC Disclosures.

Frequently, these objectives can be accomplished by smaller sized passive and active ESG integration funds. The retail retirement investor needs the “honest publicity” to make such an informed ESG choice.

2020 is An Exciting New Decade Highlighting the Role of the Retail Retirement Investor

2020 is a new decade. It is an exciting time for the retail retirement investor to cumulatively make a difference with their $8.8 trillion in IRA assets and over $5.2 trillion in defined contribution plans (401k’s) at the end of 2018, according to the Investment Company Institute.

The most effective means to choose ESG portfolio managers

All employers should replace current 401(k) Plan Sponsor investment selection training with the most basic training in the workplace on these standards, UN PRI initiatives and SASB accounting standards accompanied by SEC disclosure training on how to analyze Holdings in a mutual fund.

Such a curriculum, offered in the workplace, must be 100 percent independently written and delivered to ensure “honest publicity.”

Using SASB new material standards and United Nations’ Principles for Responsible Investment  guidelines, retail retirement investors can take a stand by choosing the SEC Registered Investment Company(s) for what they believe is material to them and our society. IRA investors can choose the mutual fund portfolio managers that they believe, “Will incorporate ESG issues into investment analysis and decision-making processes”, as the UN PRI investing principles mandate.  Employees can request top-performing ESG integration funds for their 401(k) from their employers while simultaneously requesting basic independent tools and training on evaluating ESG options, mutual fund portfolio managers’ written objections and access to online tools to analyze Holdings and portfolio turnover.  The employee is capable of working with their employer in making such ESG choices for their retirement savings.

For the SEC to understand what the individual retirement investor believes is “material” for ESG standards and SEC corporate disclosures, the retirement investor needs to make this choice, not an intermediary, since it then becomes Wall Street’s choice as to what is “material”, not the retail retirement investors’.

A Cry for a Label or Something “Material”

“Are these shrill cries from a crowd of self-appointed, self-righteous authorities, even when all they are crying for is a label” as Commissioner Peirce claims or a desperate call for immediate action by Australians at the start of our new decade?

(1) SASB Website informs: “In a marketplace saturated with sustainability information, it’s hard to know what to trust and how to decipher what really matters—which factors will drive performance and impact the bottom line. SASB sharpens the focus. With SASB’s industry-specific standards, access the research that explains which ESG factors are most likely to create — or destroy — value. And take it a step further by comparing the quality of corporate disclosures on those factors.”
(2) “The Supreme Court has decreed that investors should be shielded from immaterial disclosure, and the SEC has presumed that investors regard non-financial environmental, social, and governance (ESG) disclosure as largely immaterial. Taken together, these two factors severely limit the ESG achievements and embarrassments that companies reveal.”
(3) Cover photo source:  Wall Street Journal
(4)”Companies in different industries have different sets of material ESG risks, and those risks have different weightings. In the integrated oil and gas industry, for example, greenhouse-gas emissions, other emissions, effluents and waste from operations, management of human capital, community relations, and bribery and corruption issues have been identified by Sustainalytics as the key material ESG risks. By contrast, in the enterprise and infrastructure software industry, the most important material ESG risks include data privacy and security issues, management of human capital, and corporate governance.” Morningstar, Jon Hale, November 2019