I am pleased to be with you today to discuss attempts to use public pension funds to influence the behavior of foreign governments. Let me begin, though, with a word about the National Foreign Trade Council. Our member companies include most sectors of the U.S. economy. We represent them on issues of trade policy, international tax policy, human resource issues, and we work with them in opposing unilateral economic sanctions.
Our opposition is because the evidence persuades us that unilateral sanctions simply do not work and are usually counterproductive. Ten years ago we established a subsidiary called USA*Engage to educate Congress and the public about the futility of unilateral sanctions and why it was better to exert positive influence through diplomacy and engagement.
We have had some success with this message, though we still find ourselves all too frequently playing defense. But in the past two years we have also witnessed increased efforts by state and local governments to get into the foreign policy business by imposing sanctions against whichever country they were mad at at the time. We have opposed these sanctions not only on their merits but also because the Constitution reserves the right to conduct foreign policy to the Federal government.
To prove that point, in 1998 we sued the state of Massachusetts, challenging the constitutionality of its sanctions on companies doing business with Burma. We did not do that because we like Burma. We do not. It has a nasty regime which is a clear violator of human rights. But the Congress had already passed tough sanctions on Burma, and the Massachusetts law conflicted with them. We won that case at every level, including the Supreme Court, which in 2000 ruled unanimously that the Massachusetts law was unconstitutional. The essence of their ruling was that the President makes foreign policy, not the legislature and governor of Massachusetts. And, he does not need fifty states, or lots of cities and counties, coming along with sticks and carrots which conflict with his and which pose enormous compliance burdens on the primary victims of sanctions – US companies, banks, and asset managers.
Let me give you a hypothetical example. Suppose violence breaks out in Kashmir (not an entirely unlikely prospect). Michigan, influenced by its Muslim population, sanctions India, while California, with its large Indian population, sanctions Pakistan. Where does that leave U.S. foreign policy? I’ll quote just one passage from the Supreme Court’s decision that makes this point:
It is impossible to think that the (first) Congress would have gone to such lengths to empower the President (to conduct foreign policy) had it been willing to compromise his effectiveness by allowing state or local ordinances to blunt the consequences of his actions. The state (Massachusetts) Act undermines the President’s capacity in this instance for effective diplomacy.
For six years state and local governments heeded the Supreme Court’s ruling. Then last year in response to the genocide in Sudan, seven state legislatures passed sanctions on companies doing business in Sudan. While the Massachusetts sanctions prohibited the state government from procurement from companies did business with Burma, the Sudan and Iran sanctions target public pension funds, requiring them to sell shares of companies that have direct or indirect commercial ties to Sudan or Iran. And, of course, the laws differ from state to state, so not only is there conflict with Federal policy, but there is no consistency among the various state laws. These actions have forced us to file a second lawsuit – against Illinois – which has also been successful thus far. And my main point today is to tell you that Illinois is only the tip of the iceberg, and your funds are in serious risk of being the Titanic.
While the Sudan divestment movement may be slowing down, at least as far as new legislation is concerned, the same movement on Iran is speeding up. These bills are often broadly drafted and contain the same constitutional flaws we argued in the Illinois case, but they are moving along in legislatures, impelled by a strong national movement, aided by speeches all over the country by former Israeli Prime Minister Netanyahu, to persuade states to enact strong anti-Iran sanctions, including divestment.
And, of course, once we start down this path of instructing pension fund managers to base their investment decisions on moral rather than fiduciary principles, where will it end?. The world is not short of countries that commit human rights violations or do not practice our version of democracy. Zimbabwe. China. Russia. Saudi Arabia. I predict if we start down this road, we will soon make it very difficult for asset managers to invest profitably, which will not only do enormous damage to pension funds and retirees but also to American capital markets, as foreign companies flee the New York Stock Exchange and NASDAQ in an attempt to avoid the consequences of these laws, which will be seen by foreign companies as a continuation of increasingly complex regulation of the kind required by Sarbanes-Oxley. Capital flight is a genuine concern, and this does nothing to stem the tide.
There is no question that the Sudanese government is an outrageous violator of human rights, and the situation in Darfur is tragic. Likewise, Iran gives material support to terrorist organizations and is preventing international inspection of its nuclear program while it attempts to develop a nuclear weapons capability. The United States must address these serious problems in both countries. But the question is, how?
Activist groups have lobbied state governments, private foundations, colleges and universities to divest from companies having business ties to those countries. Private institutions are obviously free to divest as they please. (Although I noticed that two weeks ago shareholders in Berkshire Hathaway, Warren Buffet’s firm, voted 98% to 2% not to do so.) And now eleven states have so far enacted laws which require their public pension funds to divest from companies with some direct or indirect connection to Sudan. Similar legislation is pending in 15 additional state legislatures. So far nine states have sanctions legislation pending on Iran , a number that is increasing each month.
These laws are pain without gain. First the pain. We are talking about public employee pension funds, predominantly for retired teachers, firefighters and police officers. In many cases these funds are prohibited from holding individual company equities. To be in equity markets they must invest in mutual funds. As you know better than I, international mutual funds currently have higher yields than domestic funds, and it is precisely those mutual funds that public pension funds have to divest to comply with these laws. That will force them into bonds with far lower yields. In many localities, public pension funds are already significantly under funded. A requirement that they sell their most profitable investments puts their annuitants at risk and tells pension fund managers to breach their fiduciary duty. The result is that citizens who have spent their careers in public service are asked to put their retirement income at risk in a doomed effort to persuade foreign governments to change their behavior.
As many of you also know better than I, divestment is not cheap. Many of the funds you may have to sell are closed funds that you may not be able to reenter later on. Second, the cost of divesting may be substantial. In Illinois, pension fund managers found that very few mutual funds were willing to provide the Sudan-free certifications required by the state’s law. In fact one pension fund manager stated in an affidavit “it is conceivable that the Sudan Act could eliminate all mutual funds as eligible investments for Illinois pension funds. This contravenes the notion of prudence as it is commonly understood by public pension trustees and professional fiduciaries.” The estimated cost of compliance in Illinois, including the opportunity cost of lost returns, runs into the tens of millions of dollars. Florida’s law requiring divestment from Iran and Sudan-related companies is estimated to affect about $1 billion worth of investments. A report prepared for the Florida Senate estimates the administrative cost of divestment from Sudan and Iran-related assets would be as much as $65 million and the asset value loss at over $12 billion. It goes on to say,
“If this activity results in lost investment income, or administrative costs associated with divestment and replacement of divested funds, those costs will have to be absorbed by the Public Fund in the form of a revised investment policy statement or by higher payroll contribution rates.”
The estimate of Wisconsin’s costs, from the Wisconsin Legislative Council, are “up to 0.5% of the total value of all assets under management before the investment would cease,” which would mean losses of over $440 million. The report went on the say, “The administrative costs cited in the fiscal estimate are substantial and would be paid from the employee trust fund.”
That was the pain. On the question of gain, advocates of these laws ignore the fact that federal law and regulations already prohibit American companies from doing business with Sudan and Iran. As a result, the vast majority of targeted companies are European and Asian.
That means state divestment laws necessarily target foreign companies. In the case of Sudan, Chinese oil companies are primary targets. Given the appetite of countries such as China and India for energy, it is highly unlikely that they would give up access to Sudanese or Iranian oil and gas reserves because of potential decreases in share prices of their oil companies on Western stock exchanges. Moreover, the depth of Western capital markets is such that the impact of divestment on companies’ shares is not likely to be significant. So the chance that these well-intentioned laws will achieve their objectives is slim indeed. But the cost, as I’ve indicated, is not slim.
Last summer the NFTC, along with eight public pension funds as co-plaintiffs, sued the state of Illinois to test the constitutionality of its Sudan divestment law. In February the Federal District Court for the Northern District of Illinois found the law unconstitutional. The judge determined that the law’s requirement that municipal pension funds divest Sudan-related shares violated the Foreign Commerce Clause of the Constitution. State governments can, of course, invest their funds and purchase goods freely when they are acting as a normal market participant. The problem arises when their intent is not to get the lowest price or the best deal, but to affect the behavior of a foreign government. In that case the state is acting as a regulator and not as a market participant. The Illinois ruling turns in part on the judge’s view of precedents in this area and I will be happy to go into greater detail about that if you wish. The state has appealed this decision, and at the same time the legislature is considering new legislation that purports to fix the constitutional flaws in the old law. That means in all likelihood the NFTC will either have to defend its victory on appeal or return to court on the new law, if it turns out to be as flawed as the old one. Doing that will require more money, and I hope you r organization will decide to contribute to our efforts.
Finally, there are policy problems with state sanctions. In Sudan, U.S. government policy is to encourage commerce with southern Sudan to strengthen it vis-à-vis the government in Khartoum. Indeed, the U.S. Treasury Department issues licenses to companies to do business there. Some state laws make no such distinction and, therefore, target companies that are legally providing goods and services to a region where they are desperately needed.
In Iran, the President is working very hard to develop a multilateral approach to sanctions, which is the most effective approach. The state laws being proposed, however, would attack companies that are major actors – sometimes government-owned – in the very countries we are trying to persuade to cooperate with us. It is ridiculous to expect the Chinese, for example, to cooperate with us at the same time we’re beating their state-owned oil companies over the head.
We are often asked what states can do. The answer is they can pass resolutions and lobby Congress and Administration to take stronger action. However unsatisfactory this may seem to sanctions proponents, only the Federal government has the diplomatic and economic resources to move other countries and multilateral organizations to join in effective action. Quite apart from the constitutional issues raised by state divestment laws, the costs of pension fund divestment must be weighed very carefully against the prospect of the sacrifices they entail having any beneficial impact.
Finally, this divestment movement is not limited to states. It has also caught the attention of Congress. In the House, Ileana Ros-Lehtinen, the Ranking Member of the House Foreign Affairs Committee, has introduced legislation that would require divestment by federal pension funds of companies doing business in Iran’s energy sector and would impose new reporting requirements on privately managed pension and mutual fund managers. The House Financial Services Chair, Barney Frank, is likely to come out with a separate bill of his own. Bills have also been introduced in the House and Senate that would recognize and support state divestment efforts. We oppose these efforts but once again find ourselves on defense.
This is clearly an issue that has resonance at both the federal or state levels. And we can’t forget that there are clear wrongs going on in Iran and Sudan that must be righted. But it is clear that divestment will harm pensioners and pension systems more than it will fix either of those situations. And the precedent that it sets now may come back to haunt the U.S. financial community, asset managers and retirees for years to come.