Republican State Attorneys General Target Mutual Fund Directors Concerning Mutual Fund Adviser ESG Activities

At a Glance

• The letter addresses potential conflicts of interest that may arise when an asset management company, like BlackRock, both advises mutual funds and holds a stake in a wide range of companies across various sectors.
• The letter also highlights the critical role independent directors play in policing the conflicts of interest between a fund and the fund’s investment adviser.
• We provide five key takeaways for mutual fund directors.

In recent times, the focus on environmental, social and governance (ESG) investments has grown significantly. As investment decisions are increasingly aligned with ethical principles and sustainable values, the scrutiny of possible conflicts of interest and transparency of investment strategies have also intensified. ESG investing involves the consideration of environmental, social and governance factors alongside financial performance to assess the long-term sustainability and ethical impact of an investment.

In this update, we will discuss a recent letter issued by 15 Republican state attorneys general (AGs) to 10 mutual fund directors overseeing funds for which BlackRock, Inc., (BlackRock) serves as an investment adviser. The letter highlights the legal obligations of mutual fund directors to act in the best interests of the fund’s shareholders. This includes avoiding conflicts of interest and ensuring that investment decisions align with the fund’s stated objectives. The AGs urge the mutual fund directors to provide comprehensive information on the funds’ holdings, potential conflicts and the decision-making process regarding ESG investments. Putting aside the political undertones of this letter towards BlackRock, mutual fund board members must still address the legitimate grievances it raises.

Salient Points of the Letter

One of the primary focuses of the letter is addressing potential conflicts of interest that may arise when an asset management company, like BlackRock, both advises mutual funds and holds a stake in a wide range of companies across various sectors. This dual role may lead to conflicts between the adviser’s fiduciary duty to the mutual fund investors and its own financial interests. In particular, the letter questions whether the identified mutual fund boards had conducted a sufficiently thorough inquiry into BlackRock’s potential conflicts of interest and whether Blackrock should continue as an investment adviser to the mutual funds.

Under the Investment Company Act (ICA), a “fund’s board of directors is charged with the responsibility of protecting the interests of fund shareholders by overseeing the operations of the fund and policing conflicts of interests.” The SEC has long maintained its position that as a consequence of the role as “watchdogs” in policing potential conflicts of interests, fund directors have heightened exposure to personal liability for actions that they take which they believe to be in the best interests of the fund and its shareholders. This letter emphasizes these potential liabilities.

Furthermore, the letter highlights the ICA’s independent director requirement, which demands that at least 40% of the board of directors of a mutual fund must not be “interested persons” of the mutual fund. In particular, the letter seeks information from the 10 directors on their roles serving as director of the mutual fund board as well as director of any company in which BlackRock owns more than 5% of the company’s shares. The letter also indicated that some of the mutual fund directors served as employees of BlackRock. Section 2(a)(19) of the ICA grants the SEC the authority to issue an order when it finds that a person has a “material business or professional relationship” with certain specified persons and entities, including some mutual fund affiliates. Additionally, the legislative history indicates that a business or professional relationship would be material if it “might tend to impair the independence of [a] director.”

Furthermore, the letter highlights the critical role independent directors play in policing the conflicts of interest between a fund and the fund’s investment adviser. For example, the letter draws attention to the requirement under the ICA that a majority of a fund’s independent directors approve the fund’s contracts with its investment adviser. In particular, the letter questions whether BlackRock is providing all material information on potential conflicts of interest and the completeness of the processes the directors have in place to ensure against conflicts of interest by BlackRock. The AGs question whether conflicts exist concerning BlackRock’s ESG practices and whether the adviser has an incentive to implement its ESG practices favoring its large institutional clients over its retail clients.

The letter also questions the directors’ capacity to effectively oversee the fund’s investments and address potential conflicts given their other commitments. For example, the AGs state that some of the directors serve on dozens of BlackRock mutual fund boards in addition to their other commitments. The AGs raise concerns about how potential overcommitment of board directors may affect the fund’s governance and decision-making processes, particularly in relation to ESG investments and conflict resolution. In addition, the AGs point out a potential conflict of interest in BlackRock’s ESG policy, which states that BlackRock will consider voting against a director who serves on an excessive number of boards.

While BlackRock’s focus on ESG put it in the political crosshairs of Republican state AGs, many of the concerns raised in the letter focus on fund governance and conflict-of-interest concerns that are not directly related to BlackRock’s ESG policies. In this political climate, any focus on ESG by an adviser or mutual fund complex could bring added scrutiny to the governance practices of an adviser and the mutual funds it manages.

Key Takeaways

1. To address concerns about potential conflicts of interest, mutual fund boards can appoint independent directors who do not have ties to the fund investment adviser or any other entities involved in the fund’s management. Independent oversight can help ensure unbiased decision-making and promote accountability.
2. Fund board members should conduct thorough due diligence to evaluate the appropriateness of the fund adviser’s advisory role and its potential impact on the fund’s objectives. They should also assess the alignment of the fund’s investments with its stated ESG goals.
3. Regular reviews of the fund’s performance, adherence to ESG principles, and handling of potential conflicts of interest should be conducted. This practice helps ensure ongoing compliance with legal obligations and promotes responsible investment practices.
4. To ensure full compliance with legal obligations, mutual fund board members may seek legal counsel to understand their responsibilities and obligations under relevant laws and regulations. Legal advice can help guide their decision-making processes.
5. Continuous education and awareness about responsible investing practices, ESG criteria and the particular ESG integration engaged in by the fund will empower board members to satisfy their legal obligation to act in the best interests of the fund’s shareholders.