The US Department of Labor released a final rule reframing how ERISA-regulated fiduciaries can consider environmental, social, and governance factors in retirement plan investment decision making.
The US Department of Labor (DOL) released a final regulation, informally known as the “ESG Rule,” on November 22, 2022, titled “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” (Final Rule). The Final Rule reframes how fiduciaries regulated by the Employee Retirement Income Security Act of 1974, as amended (ERISA), can consider environmental, social, and governance (ESG) factors in fiduciary investment decision making for retirement plans. The Final Rule also clarifies how fiduciaries can satisfy their duties when voting proxies and exercising other shareholder rights for plans.
The Final Rule clarifies that ERISA-regulated fiduciaries may take into account ESG factors that are relevant to an investment’s expected risk return and other financial factors. While the Final Rule gives a (green) thumbs up to ESG investing in certain circumstances, when considered against the proposed version of the rule published by the DOL in October 2021 (the Proposed Rule), it deemphasizes ESG factors specifically and instead provides a more principles-based gloss on appropriate fiduciary decision making processes in general. Notably, the Final Rule does not suggest or require that ERISA fiduciaries must consider ESG factors in investment decision making.
Morgan Lewis posted an initial summary of the rule in the ML BeneBits blog, as well as a brief summary and a longer analysis of the proposed version of this rule published by the DOL in October 2021 (the Proposed Rule).
The key ERISA issue presented by ESG investing is the extent to which consideration of ESG factors can be consistent with ERISA’s stringent fiduciary duties of loyalty and prudence. ERISA’s duty of loyalty requires fiduciaries to act solely in the interest of the plan participants and beneficiaries when making fiduciary decisions. ERISA’s duty of prudence requires a fiduciary to act “with the care, skill, prudence, and diligence” that a prudent person would use.
The DOL has grappled with this issue in various forms for over several decades, in a manner often resembling a ping-pong match, as positions bounce back and forth with changing presidential administrations. The guidance over the years, however, has uniformly required that any consideration of ESG or similar factors in investment decision making must satisfy the duties of loyalty and prudence.
The most recent volley prior to the Final Rule is the regulation adopted in 2020 titled “Financial Factors in Selecting Plan Investments” (2020 Rule). The 2020 Rule interpreted the duty of loyalty and the duty of prudence in a manner reflecting skepticism that consideration of ESG factors could be consistent with those duties. The 2020 Rule also overhauled long-standing DOL guidance on proxy voting and the exercise of other shareholder rights.
The current leadership at the DOL was concerned that the 2020 Rule created uncertainty with respect to ESG investing and the perception that fiduciaries were at risk if they included any ESG factors in their evaluation of investments. The DOL stated that it intends the Final Rule to address the chilling effect that it believes the 2020 Rule created with respect to the consideration of ESG factors in selecting investments and exercising shareholder rights.
The Final Rule was expected to take a more pro-ESG approach and as expected, the DOL’s new regulation should provide some clarity and flexibility for fiduciaries regarding the permissible role of ESG factors in investment decision making.
Below is a summary of four key takeaways, noting areas in which the Final Rule differs from the 2020 Rule:
1. The Final Rule takes a more neutral, middle-of-the-road approach to ESG factors, clarifying that taking into account ESG factors is permissible but not prescribed.
The Final Rule clarifies that ESG factors may be financially relevant factors considered and may appropriately be included as part of ERISA fiduciary investment decision making. While the Proposed Rule suggested there may be circumstances where consideration of certain ESG factors must be considered, the Final Rule includes no such requirement. Instead, under the Final Rule, ESG factors can take their place among the many factors that ERISA fiduciaries may consider when making investment decisions. ESG factors do not require special treatment or special documentation.
A central test under the Final Rule is that investment factors, including ESG factors, can be considered if they are “relevant to the particular investment or investment course of action” (which DOL has generally interpreted to mean factors that are financially relevant) so long as they do not subordinate participants’ interest in “retirement income or financial benefits.” While the Final Rule (and prior DOL guidance in this area) has been commonly referred to as the ESG regulation, notably the standards in the Final Rule seem to apply more broadly beyond ESG and may allow consideration of other non-traditional factors beyond ESG factors (so long as they are financially relevant).
Observation: With the Final Rule, the DOL intentionally takes an approach intended to achieve “appropriate regulatory neutrality,” which could serve to insulate this rule from further regulatory ping-pong in the future. We expect this principles-based approach will be welcomed by ERISA stakeholders who believe that ESG should have a place in retirement plan investing (because the interpretation will reduce barriers to ESG usage) as well as those stakeholders seeking to end uncertainty with a more durable regulation.
2. The Final Rule broadens applicability and eases application of the “tie-breaker test.”
Prior DOL guidance included the notion of permitting ESG or similar factors to be used to break a “tie” between investments under consideration. The 2020 Rule set up a challenging (some might say highly unlikely) scenario under which a fiduciary could consider collateral factors (i.e., those that are not directly related to the financial performance of the investment in question) only when “breaking a tie” among investment alternatives that could not be distinguished based on “pecuniary factors” alone.
The Final Rule, in contrast, does not require the investments to be indistinguishable to allow for consideration of collateral benefits. Rather, it allows for consideration of collateral benefits where “competing investments . . . equally serve the financial interests of the plan.” Also, the Final Rule removes the documentation process that accompanied tiebreakers under the 2020 Rule.
Observation: This new test should allow fiduciaries more flexibility to consider “collateral benefits” because it only requires an investment selected for such collateral benefits to equally serve the plan’s financial interests, rather than be indistinguishable. Also, “collateral benefits” are not defined and are not limited to ESG factors and so, in theory, could include non-ESG collateral benefits.
3. The Final Rule allows fiduciaries of participant-directed plans selecting plan investment options to consider participant preference, in certain circumstances.
The Final Rule adds a new provision not included in prior iterations of this regulation, stating that fiduciaries of participant-directed individual account plans do not violate the duty of loyalty solely by considering participant preferences as part of their investment decision making process, as long as the other requirements under the Final Rule are met. The DOL states that this provision is not intended to be novel or a change in DOL position. It is, however, the first time DOL has explicitly addressed the role of participant preference in a regulation. It is important to note that this provision only addresses the duty of loyalty, not the duty of prudence. Thus, a fiduciary may not honor participant preference for investment options unless the fiduciary believes the options are prudent.
Observation: We suspect that this provision may have been driven by the research cited in the preamble supporting the notion that accommodating participant preferences, such as a preference for an ESG-themed investment option, may drive higher retirement plan participation and deferral rates, which could lead to greater retirement security. On the one hand, we expect this will be a welcome clarification (or confirmation) for some ERISA fiduciaries who may have been concerned that consideration of participant requests for an ESG investment option could be construed as subordinating the interest in retirement income or financial benefits under the plan. On the other hand, there remain open questions about how this consideration of participant preference will be put in practice. For example, what about competing participant preferences? And how much weight will courts give to a fiduciary’s consideration of participant preference when the investment is challenged as imprudent?
4. The Final Rule reaffirms the fiduciary duty to vote proxies and exercise shareholder rights.
The Final Rule reemphasizes a long-standing DOL principle that a fiduciary’s duty to manage plan assets includes the appropriate exercise of shareholder rights related to those shares, including the right to vote proxies. The Final Rule removes provisions included in the 2020 Rule that some read as increasing the regulatory burden for an ERISA fiduciary to vote proxies and exercise other shareholder rights.
While the 2020 Rule did not negate the fiduciary duties applicable to proxy voting and the exercise of other shareholder rights, some viewed the rule as downplaying the importance of, or discouraging, proxy voting and the exercise of shareholder rights by fiduciaries. The Final Rule returns to an interpretation clarifying that fiduciaries should vote proxies unless they have a good reason not to (e.g., if there would be significant costs involved).
Observation: The proxy voting and shareholder rights portion of the Final Rule also reflects the DOL’s intended shift to a more neutral and principles-based approach in the Final Rule. Compared to the Prior Rule, this rule opens the door to increased participation in proxy votes and other shareholder actions, as long as the issue up for vote is (ESG or not) financially relevant to the investment.
While this rule is final, it is not yet effective. Most provisions of the Final Rule (other than certain proxy voting provisions for proxy advisory firms and pooled investment funds) will be effective 60 days after publication in the Federal Register, which is expected imminently but has not yet occurred as of the publication of this LawFlash. ERISA fiduciaries will want to review their current investment policy statements and guidelines in light of these rule changes, including to determine whether any changes can or should be made to reflect the additional flexibility the Final Rule affords.
No discussion of next steps for the Final Rule would be complete without an acknowledgement of the larger political and cultural environment surrounding ESG in the United States. Some members of Congress have expressed opposition to the Final Rule, with a few characterizing it as requiring consideration of ESG factors, and have expressed an intent to introduce (or have already introduced) legislation to amend ERISA to explicitly prohibit consideration of ESG factors. Further, many US states are forging ahead with their own regulations both promoting and circumscribing the use of ESG factors in their own state retirement programs.
With the next US presidential election less than two years away, any change in administration always brings the risk of a change in regulations. So, while the Final Rule provides what we believe many will consider welcome clarity, the current political environment may make certainty in this area elusive.
Morgan Lewis stands ready to assist clients who wish to review their investment decision making processes or proxy voting practices, including for plans and investment processes that already consider ESG factors or utilize an ESG fund or mandate. Morgan Lewis also helps clients that seek to navigate other ESG issues, such as pro-ESG stakeholder interest or changing investment options in a defined-contribution investment line-up, in response to the Final Rule.
More broadly, Morgan Lewis has established ESG, corporate sustainability, and climate change teams dedicated to helping clients navigate the evolving incentives, restrictions and requirements on a global scale. Information about our initiatives in this space is available on our Navigating the NEXT. ESG page.
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