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At the same time that the federal government, through the US Department of Labor, appears to be easing retirement plan fiduciaries’ paths to considering certain environmental, social, or governance (ESG) factors in making investment decisions, some states are passing legislation that would prohibit the states from doing business with managers who invest based on ESG criteria. These anti-ESG state legislative efforts could complicate the use of ESG by public retirement plans and put retirement plan fiduciaries and providers of retirement plan investment products in a tricky spot, looking to bridge their fiduciary obligations with these new limitations. These legislative activities could also create challenges for investment providers seeking to simultaneously serve both public and private retirement plans.

The Department of Labor regulates the majority of US employer-sponsored retirement plans through the Employee Retirement Income Security Act of 1974 (ERISA), but public retirement plans are not subject to ERISA’s requirements and are instead regulated by state and local laws. Some states use ERISA’s framework as a standard for their public pension statutes, either directly or indirectly. There are currently over 5,500 of these state and local government-sponsored pension plans, with close to 21 million participants and $4 trillion in assets. These public retirement plans account for close to 20% of total US retirement savings assets.

Over the past year, 17 states have proposed or adopted state legislation that would limit the ability of the state government, including public retirement plans, to do business with entities who are identified as “boycotting” certain industries based on ESG criteria or goals or who consider ESG factors in their investment processes.

These “anti-ESG bills” operate in different ways. Some ban government contracting with companies identified by the state officials as “discriminating” against certain industries, including the firearms industry or the fossil fuels industry. For example, Texas has enacted SB 19, prohibiting a government entity from contracting with companies for over $100,000 unless the company verifies in writing that they will not discriminate against a firearms entity or a firearms trade association.

Other types of anti-ESG bills ban state funds, such as state retirement plans, from investing in ESG-type investment products. For example, Kentucky has enacted SB 205, mandating that state government entities must divest from financial companies that boycott energy companies. Some states have only enacted or proposed one type of bill (for example, West Virginia’s SB 262 and Utah’s HB 312 ban certain types of government contracting with companies that “discriminate” against energy companies, but don’t mandate state divestiture) while other states have proposed or enacted both types of anti-ESG bills (for example, Oklahoma’s HB 2034 and HB 3144 and Louisiana’s HB 25 and HB 978).

Texas led the state push to increase scrutiny over ESG investing with the passage of both types of anti-ESG laws in May of 2021. Texas’ SB 13 is directed squarely at state-held retirement funds and permanent school funds and mandates divestiture from companies that “boycott” the fossil-fuel industry. The funds impacted by this law are worth approximately $330 billion, though it’s unclear how much of those assets are invested in companies that would be considered to be “boycotting” the fossil fuel industry. The law would also prohibit the Texas state government and municipalities from entering into any contract with a vendor valued at over $100,000 unless the vendor represents that it does not and will not for the term of the contract “boycott” energy companies as defined in the Texas statute.

Texas SB 13 defines “boycott” very loosely—even firms that invest in fossil fuels but also offer fossil-fuel free financial products could be caught in the ban. As a former Texas lawmaker who formerly helped oversee pension fund investments explained, “If they have any mutual funds or exchange traded funds in their portfolios that prohibit or limit investment in fossil fuels, then that is problematic.”

That said, the specific terms of the rule leave room for some interpretation. For example, it is not clear that a firm that avoids doing business with energy companies would instantly be considered to be “boycotting” energy companies. The Texas law provides an exception for companies acting with a “normal business purpose,” and the definition presents its own complications.

Specifically, the definition of “boycott energy companies” requires the determination to avoid doing business with the energy company to be based on two prongs:

  • because the company engages in the exploration, production, utilization, transportation, sale, or manufacturing of fossil fuel-based energy; and
  • the company does not commit or pledge to meet environmental standards beyond applicable federal and state law.

This two-pronged approach could leave open the possibility that a financial company could refuse to do business with an energy company without “boycotting” the energy company under Texas law as long as that refusal was not motivated by the failure of the company to adopt heightened environmental standards.

More recently, Florida governor Rick DeSantis announced in July 2022 his plan to propose a Florida state bill that would prohibit the Florida State Board of Administration (SBA) from engaging investment managers who consider ESG criteria when managing state assets, including state-sponsored pension funds. The proposed legislation would amend Florida’s state statute on deceptive and unfair trade practices to “prohibit discriminatory practices by large financial institutions based on ESG social credit score metrics,” and would require SBA fund managers to “only consider maximizing the return on investment on behalf of Florida’s retirees.”

On the federal level, ERISA has long required that retirement plan fiduciaries make decisions solely in the best interests of the plan participants and beneficiaries and for the exclusive purpose of providing benefits to participants and their beneficiaries (see 29 CFR 2550.404a-1(a)). Whether and how ESG factors can be considered has been a game of regulatory ping pong, changing with successive presidential administrations.

The recently proposed version of the Department of Labor’s ESG investing guidance reiterated ERISA’s focus on participants’ financial interests, requiring that a fiduciary “may not sacrifice investment return or take on additional investment risk to promote benefits of goals unrelated to the interest of the participants and beneficiaries in their retirement income or financial benefits under the plan.” (see 86 Fed. Reg. 57302, 57303 (Oct. 14, 2021)). The proposed rule also states that “[a] fiduciary’s evaluation of an investment or investment course of action must be based on risk and return factors that the fiduciary prudently determines are material to investment value.”

The Department of Labor appears to be trying to clarify that ESG factors can be considered where they are material to an investment. This DOL approach is in contrast to the recent anti-ESG state bills that seem to be aimed at discouraging the use of ESG investing. These anti-ESG state legislative efforts could complicate the use of ESG by public retirement plans and create challenges for retirement plan fiduciaries. The distinction could also create headaches for investment providers seeking to serve both public retirement plans and ERISA-governed plans.

If you have any questions about how these federal or state regulations may impact public or private retirement plan investment or impact, corporate activities, or investment products, please reach out to any of the authors of this article or your other Morgan Lewis contacts.