Once CalSTRS is finished with guns, are HSBC and UBS next?

News report: CalSTRS Reviewing All Gun-Related Investments

The team at the California State Teachers Retirement System (CalSTRS) is doing the right thing. Stewards of investment capital have every right to consider a variety of factors before making an investment. There are the usual financial metrics, but forms of “socially responsible investing” (SRI) are certainly acceptable if it suits the proponents of a capital pool or their beneficiaries.

The issue is tougher, of course, if the taxpayer is on the hook for any shortfall that might arise from SRI — unless the taxpayers themselves are supportive of SRI, too.

SRI isn’t a new topic, and can take many forms depending on the audience: corporate governance, consumer protection, Diversity, environmental protection, human rights and social justice. For some institutional investors, such as University endowments, Church pension plans or medical agencies, SRI could include some form of proactive investment avoidance of businesses involved in alcohol, gambling, military equipment, porn and tobacco. Government arms might not want to be involved with AshleyMadison.com, for example, in case they were accused of facilitating philandering. The scenarios are endless.

Firms such as Reynders, McVeigh Capital Management in Boston, for example, have built investment strategies for high net worth individuals and institutions that want a “forward-thinking selection of socially responsible investments” or to affect positive change in society. In this day and age, who would be against “ethical investing”?

University campuses have been natural flashpoints for the tension between investing for the highest return on an arms-length basis and making a political or social statement with your investment capital. In 1988, the topic on the University of Toronto campus was “divestment from South America in light of humanitarian concerns” (H/T The Strand). Ten years later, the continent of focus was Africa, and U of T’s investments in Total SA and Alcatel were under attack; in the view of some students, owning these shares meant that their Institution of Higher Learning was supporting “government-sanctioned genocide in Sudan”.

The reason? If Alcatel and Total SA withdrew their foreign investment, nations could “put economic pressure on the government to seek a peace agreement”, and that a “withdrawal of the [foreign direct investment] would not only reduce the government’s ability to fund its extinction campaign but also symbolize international intolerance of human rights atrocities in the form of economic punishment.” I suppose the students were right, even if the U of T Governing Council turned them down. If American money managers don’t want North Korea to build a nuclear weapon, they shouldn’t be investing in its high tech industry (and they don’t).

In the wake of the horrific murders in Newtown, Connecticut, the Treasurer of California had this to say to the WSJ:

CalPERS and CalSTRS should not be invested in any company that makes guns which are illegal in California,” Mr. Lockyer said in a statement. “These weapons have no place in our communities. Our families and children are safer without them.”

CalSTRS issued a media statement reminding its external investment advisors (including Cerberus, owner of the Freedon Group, maker of the XR-15 assault rifle used in Newtown) that there was more to investing its capital than simply trying to make the most money before you die:

“CalSTRS has established a thorough vetting process for potential investments that seeks to test not only their financial potential, but their social, human and environmental impacts as well. In fact, current policies require that the risks associated with products that pose significant threats to human well-being be taken into account before an investment is made by CalSTRS investment managers. They are outlined in CalSTRS 21 Risk Factors, which we adopted in 2008….”

The 21 CalSTRS Risk Factors cover a range of important issues, including:

“Accounting: The long-term profitability by whether or not the accounting standards are formulated in accordance with International Accounting Standards or the U.S. Generally Accepted Accounting Principles.”

“Data Dissemination: The long-term profitability by whether or not a country is a member of the IMF (or similar organization) and satisfies the conditions for access, integrity, and quality for
most data categories.”

“Human Health: The risk to an investment’s long-term profitability from business exposure to an industry or company that makes a product which is highly detrimental to human health so that it draws significant product liability lawsuits, government regulation, United Nations sanctions and focus, and avoidance by other institutional investors.”

“Fiscal Transparency: The investment’s long-term profitability by its exposure or business operations in countries that do not have not some level of fiscal transparency such as publication of financial statistics, sound standards for budgeting, accounting, and reporting.”

“Money Laundering: The investment’s long-term profitability from exposure and whether or not a country has implemented an anti-money laundering regime in line with international standards; consideration should be given to compliance with the 40 recommendations in the Financial Action Task Force (FATF) on Money Laundering; and whether it is a member of FATF.”

“Respect for Human Rights: The investment’s long-term profitability from its business operations and activities in countries that lack or have a weak judicial System. Assess the risk to an investment’s long-term profitability from its business operations and activities in a country that engages in or facilitates the following: arbitrary or unlawful deprivation of life, disappearance, torture and other cruel, inhuman, or degrading treatment or punishment, arbitrary arrest, detention, or exile, arbitrary interference with privacy, family, home, or correspondence, use of excessive force and violations of humanitarian law in internal conflicts. Consideration should be given to governmental attitude regarding international and non-governmental investigation of alleged violations of human rights.”

“Securities Regulation: The long-term profitability by exposure to operations in countries that have not complied with IOSCO objectives, which provide investor protection against manipulation and fraudulent practices.”

Sounds pretty straightforward, even on a macro basis. But, like most policies, the implementation is key. And this is where the CalSTRS 21 Risk Factors become less clear cut then the media have reported to date. The introduction to the guidelines largely undercuts the entire directive, as you’ll see in bold:

Geopolitical Risks and Social Risks: To help manage the risk of investing a global portfolio in a complex geopolitical environment, CalSTRS has developed a series of procedures to follow when faced with any major geopolitical and social issue as identified by the 21 risk factors. It is important to note that fiduciary standards do not allow CalSTRS to select or reject investments based solely on social criteria.

To assist CalSTRS Staff and external investment managers in their investment analysis and decision-making, CalSTRS has developed a list of 21 risk factors that should be included within the financial analysis of any investment decision. This list is not exhaustive and does not attempt to identify all forms of risk that are appropriate to consider in a given investment transaction; however they do provide a framework of other factors that might be overlooked. These risk factors should be reviewed for an investment in any asset class whether within the U.S. or across the globe.

CalSTRS expects all investment managers, both internal and external to assess the risk of each of the following factors when making an investment. The manager needs to balance the rate of return with all the risks including consideration of the specific investments exposure to each factor in each country in which that investment or company operates.

For Cerberus, they could simply say that they balanced the rate of return with the risks and concluded that as fiduciaries, they couldn’t “select or reject investments based solely on social criteria” and therefore complied with the CalSTRS policy, even though it was promulgated in 2008, after Cerberus received the 2007 US$500 million CalSTRS commitment.

I’m not trying to compare mass murder in the U.S. Northeast to mass murder in Darfur to the sale of tobacco (which led to 160,340 U.S. deaths in 2011) to the sale of alcohol (which led to 10,228 drunk driving deaths in 2010…about the same as the number of gun deaths in the USA in any given year). That topic is best left to the current students in the Philosophy 2074F – Business Ethics course at Western University. The life of a single six year-old can’t be traded for any amount of money.

If pension plans want to provide money managers with guidelines for how their capital should be deployed, that’s their right. The money manager can either accept the mandate, or hand it over to the next firm in the queue.

The CalSTRS policy gives its Chief Investment Officer the right to consider “the gravity of the situation both as an ESG risk and as to the [CalSTRS] System,” which in part is determined by “1) the number of shares held in the corporation, and 2) the gravity of the violation of CalSTRS Policies.”

Although the Cerberus/CalSTRS relationship got the headlines, CalSTRS is long the shares of several gun manufacturers, according to an analysis by the WSJ: ~$4 million in shares of Sturm, Ruger (RGR:NYSE) and $1.7 million of Smith & Wesson Holding Corp. (SWHC:Q). These shares are likely owned via index funds, and the positions aren’t large enough to trip point #1 above, which demonstrates how hard it is for a huge pension plan to tackle this issue.

By hitting the sell button on gun manufacturers, and staying away from tobacco shares, the CalSTRS Trustees have demonstrated that they will react quickly to developments as they arise. Which brings us to HSBC and UBS, to cite two big names that are “behind bars” right now. When HSBC was fined US$1.9 billion the other day for money laundering, and UBS paid a US$1.5 billion fine this morning and admitted that “dozens” of its staff were involved in “fraud” as they manipulated LIBOR, each bank went offside one or more of CalSTRS specific 21 Risk Factors.

On December 31, 2011, CalSTRS owned almost $500 million worth of HSBC shares and bonds. The institution’s UBS stake was worth about $40 million as of June 30, 2012. Each position is far larger than the relatively small stakes that CalSTRS has/had in firearm manufacturers. Having satisfied the “number of shares” threshold, the question then becomes how “grave” are the violations of CalSTRS policies?

According to the U.S. DoJ, HSBC “moved US$881M for two drug cartels in Mexico and Colombia and accepted US$15B in unexplained ‘bulk cash’, across the bank’s counters in Mexico, Russia and other countries.” As The Guardian put it, “in some branches the boxes of cash being deposited were so big the tellers’ windows had to be enlarged.” Hard to deny that HSBC broke the CalSTRS money-laundering rule above.

Since “fraud” is a criminal offence, and was undertaken at UBS on a wide scale basis by a large number of well-paid staff, UBS is no better off than HSBC when you consider the CalSTRS rules about Fiscal Transparency and Securities Regulation.

One industry expert called it a slippery slope. But I don’t see it that way. Now that CalSTRS has shown its investment managers that they are expected to comply with its 21 rules, it can’t be very long before the HBSC and UBS positions join Altria, Ruger and S&W on the radioactive list. The “crimes” were different, and some didn’t involve a tragic loss of life. But they were serious crimes nonetheless under the terms of the 21 CalSTRS guidelines.

It won’t bring back 20 little ones in Newtown, and no pension plan can change the gun laws or prevent bad behaviour at an international financial institution; but CalSTRS may soon show the world that every industry is expected to be ethical if it is going to attract or retain investment capital.

MRM