On June 23, 2020, the Department of Labor (“DOL”) issued a proposed rule on plan fiduciaries’ duties when considering investments that incorporate environmental, social, and governance (“ESG”) factors. Now plan fiduciaries, asset managers, and other stakeholders in the investment chain are being asked to weigh in. Building on past DOL guidance, the new rule would further explain how plan fiduciaries’ duty of prudence to plan beneficiaries applies in the context of these types of investments.
The proposed rule is an interpretation of the Employee Retirement Income Security Act of 1974 (“ERISA”), which sets minimum standards for private (i.e., corporate) retirement plans. While it will not apply to mutual funds or state pension funds per se, many states look to ERISA to inform their application of state law governing such funds. And many asset managers work with both ERISA and non-ERISA plans and may seek to apply ERISA standards across their business.
Under ERISA, plan fiduciaries must act solely in the interest of the plan participants and beneficiaries and for the “exclusive purpose” of providing benefits and paying reasonable administrative expenses. The DOL has put out guidance on multiple previous occasions on how that duty applies to ESG considerations (leaning one way during Democratic administrations and the other way during Republican administrations). Generally, that guidance has established what is sometimes called the “tie-breaker” or “all things being equal test,” which essentially permits a fiduciary to use non-economic factors as a tie-breaker for two equivalent investments.
The Proposed Rule
The core of the rule would provide that ESG factors may only be taken into consideration if they “present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories.” As the Secretary of Labor, Eugene Scalia, explained the proposed rule: “Private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan. Rather, ERISA plans should be managed with unwavering focus on a single, very important social goal: providing for the retirement security of American workers.”
The DOL’s proposing release does acknowledge that ESG considerations may affect an investment’s economic performance. For example, the DOL cites “a company’s improper disposal of hazardous waste” and “dysfunctional corporate governance” as examples of ESG considerations that could be “appropriate economic considerations.” The DOL seems skeptical that this would often be the case, however, and suggests some types of ESG factors are being used today either without sufficient analysis or rigor or explicitly to advance social welfare, rather than maximizing financial returns.
The proposed rules preserve the tie-breaker test, but impose additional documentation requirements on plan fiduciaries basing a decision, in part, on non-pecuniary factors. The rules would also prohibit the use of ESG-themed funds as qualified default investment alternatives (“QDIAs”) in defined contribution plans.
The rules would not apply to proxy voting or other engagement on corporate governance issues.
Next Steps and Reaction
The proposed rules will be open for a 30-day comment period. Interested parties can submit their comments here. Commentators have suggested that the DOL will be eager to try to finalize the rules and have them be effective before the end of the current Administration. Since the proposed rules were just released, few groups have taken positions on them yet. Of those that have, a unit of the Chamber of Commerce has come out against them on the grounds that they impose too much litigation risk and documentation requirements on corporate plans. From a different perspective, the UN PRI suggested the proposed rules are based on a fundamental misunderstanding of ESG: “ESG isn’t an asset class, but rather prudent risk management.” Some have also suggested, particularly since the rule is not very clear in explaining which funds use ESG factors and are therefore covered, that the proposed rules could discourage the inclusion of active funds in plan lineups or least as a QDIA.
This is just one manifestation of the current Administration’s apparent concern about investors’ increasing use of ESG considerations. Several other initiatives are underway or forthcoming:
- The DOL currently has an initiative underway in which it is collecting information from plan sponsors about their ESG activities, which apparently extends to proxy voting as well as investment decisions;
- The DOL has a separate rulemaking project on proxy voting and proxy advisors that was originally scheduled to be released this past Winter. It is unclear whether the DOL has delayed that rulemaking pending completion of the SEC’s or whether it will also be released in the near future; and
- The SEC has issued a request for comment on the criteria for mutual funds to refer to ESG in their name.
Private plan fiduciaries, asset managers and other stakeholders will want to closely monitor these regulatory developments as they progress.