The last year of the Trump Administration brought a regrettable effort by the Department of Labor, under its then-Secretary Eugene Scalia, to use the regulatory process to disenfranchise retirement plan investors. Spurred by an Executive Order intended to promote the domestic fossil-fuel industry, DOL changed the ground rules of retirement plan investing and stewardship in the last days of the Administration. Specifically, DOL rammed through two rules after 30-day comment periods — and despite a mountain of opposition from investors, associations and public interest groups — that made it harder for retirement plan fiduciaries to consider ESG factors in their investment decisions, and that sought to bias them against proxy voting and other basic exercises of shareholder rights.
Fortunately, both the process and substance of these “midnight regulations” marked them as prime candidates for reversal by the current Administration. And now, regulators have begun the necessary repair work. On March 10, 2021, DOL announced that it was re-examining these rules, and that, pending its review, it would not enforce them. And, on October 13, 2021, DOL proposed changes to eliminate and revise the most problematic elements of these rules.
The DOL’s proposed amendments will be open for comment until December 13, 2021. We encourage all interested parties to review them and consider weighing in.
Background
The rules at issue are an interpretation of the Employee Retirement Income Security Act of 1974 (“ERISA”), which sets minimum standards for certain private-sector (e.g., corporate and union) retirement plans. While ERISA does not apply to state or local pension funds, many states look to it 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 uniform standards across their business.
Under ERISA, fiduciaries (e.g., plans and their asset managers) must act solely in the interest of plan participants and beneficiaries and for the “exclusive purpose” of providing benefits and paying reasonable administrative expenses. The DOL rules codify this basic responsibility and then elaborate on what it means for an ERISA fiduciary to act with prudence and loyalty in making investment and stewardship decisions on behalf of a plan.
ESG Considerations in Investment
First, DOL proposes to remove special requirements, burdens and uncertainty the 2020 rule changes created with respect to considering ESG factors in investment decisions.
To do so, the proposal would eliminate the novel and unclear concept of only considering “pecuniary factors” and instead clarify that a prudent fiduciary may consider any factor material to the risk-return analysis, including climate change and other ESG factors. In fact, DOL explains in the release that “material climate change and other ESG factors are no different than other ‘traditional’ material risk-return factors,” and that the rule changes are intended to “remove any prejudice to the contrary.” The amended rules would give three examples of such factors:
- Climate change-related factors, such as a corporation’s exposure to the real and potential economic effects of climate change including exposure to the physical and transitional risks of climate change and the positive or negative effect of Government regulations and policies to mitigate climate change;
- Governance factors, such as those involving board composition, executive compensation, and transparency and accountability in corporate decision-making, as well as a corporation’s avoidance of criminal liability and compliance with labor, employment, environmental, tax, and other applicable laws and regulations; and
- Workforce practices, including the corporation’s progress on workforce diversity, inclusion, and other drivers of employee hiring, promotion, and retention; its investment in training to develop its workforce’s skill; equal employment opportunity; and labor relations.
The DOL also proposes changes to the 2020 rule’s codification of the so-called “tie-breaker” test, which permits an ERISA fiduciary to consider collateral benefits (i.e., those other than investment returns) when choosing between investments that would “equally serve the financial interests of the plan.” The amendments would clarify that the two investments do not have to be “indistinguishable” for collateral benefits to be considered. To avoid any chilling effect on use of the tie-breaker, the amendments would also eliminate the special documentation requirement added in 2020 that applies when collateral benefits are considered.
Finally, DOL’s amendments would eliminate the provision in the 2020 rules that prohibited the use of ESG funds as qualified default investment alternatives (“QDIAs”) in defined contribution plans. As DOL explains, “[i]f a fund expressly considers climate change or other ESG factors, is financially prudent, and meets the protective standards set out in the Department’s QDIA regulation…, there appears to be no reason to foreclose plan fiduciaries from considering the fund as a QDIA.” In cases where a designated investment alternative in a participant-directed defined contribution plan, including a QDIA, is chosen based on collateral benefits, however, those benefits would have to be prominently disclosed to plan participants.
Proxy Voting and Other Exercises of Shareholder Rights
Next, DOL proposes to remove aspects of the 2020 rules that added burdens and sought to discourage ERISA fiduciaries from stewardship activities. DOL identifies four primary changes to this part of the rule:
- Eliminating language discouraging proxy voting.
First, DOL proposes to eliminate the statement in the current rule that “[t]he fiduciary duty to manage shareholder rights appurtenant to shares of stock does not require the voting of every proxy or the exercise of every shareholder right.” While this change would not mean that plan fiduciaries must always vote proxies or engage in shareholder activism, DOL notes that this statement could be misunderstood to mean that fiduciaries should be indifferent to exercising their rights as shareholders. Avoiding this misunderstanding is particularly important, DOL notes, “in circumstances where the cost is minimal as is typical of voting proxies.”
This amendment reflects a sharp and welcome departure from the unbalanced emphasis on costs and minimization of the benefits of proxy voting in the 2020 rulemaking. In the regulatory preamble to its new rules, DOL recognizes that the “exercise of shareholder rights is important to ensuring management accountability to the shareholders that own the company.” And that “[i]n general, fiduciaries should take their rights as shareholders seriously, and conscientiously exercise those rights to protect the interests of plan participants.” DOL also adds a pointed rejoinder to the repeated suggestions in the 2020 rulemaking that fiduciaries should opt out of voting to save costs: “The solution to proxy-voting costs is not total abstention, but is, instead, for the fiduciary to be prudent in incurring expenses to make proxy decisions and, wherever possible, to rely on efficient structures (e.g., proxy voting guidelines, proxy advisers/managers that act on behalf of large aggregates of investors, etc.).”
- Eliminating special monitoring obligations.
Next, DOL proposes to eliminate a provision in the 2020 rule that imposed a specific monitoring responsibility “[w]here the authority to vote proxies or exercise shareholder rights has been delegated to an investment manager . . . or a proxy voting firm or other person who performs advisory services as to the voting of proxies.” As DOL notes, another part of the rule already imposes a more general duty of prudence and diligence in the selection and monitoring of stewardship service providers.
This change avoids redundancy in the rule and related uncertainty for ERISA fiduciaries. In its 2020 rulemaking, DOL never adequately explained what was required by this provision, let alone substantiated why it was necessary. As DOL explains in its current proposal, since the general prudence and loyalty duties of ERISA already impose a monitoring requirement, the 2020 rule’s additional provision could have been misunderstood as requiring some special, undefined obligations above and beyond these statutory obligations.
- Eliminating the Safe Harbors.
DOL also proposes to eliminate the two controversial “safe harbor” examples in the 2020 rule –
- A policy of only voting on “particular types of proposals that . . . are substantially related to the issuer’s business activities or are expected to have a material effect on the value of the investment” (DOL’s preamble had suggested such a policy might involve voting only on special situations, such as M&A transactions and contested elections of directors); and
- A policy of not voting unless the plan’s holding of the company involved exceeds a threshold of the plan’s total holdings (DOL’s preamble had suggested 5% as a possible threshold).
As DOL notes, characterizing an aspect of the rule as a “safe harbor” invites it to be widely adopted, making it especially important that it adequately safeguard the interests of plan participants. Again, however, DOL never explained in the 2020 rulemaking how these safe harbors were consistent with a fiduciary’s general duties of prudence and loyalty to plan participants, let alone why ERISA should steer fiduciaries into them. DOL also notes the vagueness of the first safe harbor and that the second one has practical limitations, since many investment managers of sub-portfolios of ERISA investment vehicles would not necessarily have the information to calculate this threshold. At a more general level, DOL recognizes the misguided intent and overall effect of the two safe harbors:
[T]he Department believes that the ‘‘no vote’’ statement . . . of the current regulation and the two safe harbors . . . of the current regulation, in combination, may be construed as little more than regulatory permission for plans to broadly abstain from proxy voting without properly considering their interests as shareholders and without legal repercussions.
- Eliminating Special Documentation Requirements
Finally, DOL proposes to eliminate the requirement added in 2020 that plan fiduciaries “[m]aintain records on proxy voting activities and other exercises of shareholder rights.” DOL guidance has traditionally taken a more flexible, principles-based approach to documentation of fiduciary monitoring. DOL notes that, by departing from that precedent and creating a documentation requirement just for stewardship, this provision, “in context, . . . may create a misperception that proxy voting and other exercises of shareholder rights are disfavored or carry greater fiduciary obligations, and therefore greater potential liability, than other fiduciary activities.” As DOL further notes, “[s]uch a misperception may potentially chill plan fiduciaries from exercising their rights, or result in excessive expenditures as fiduciaries over-document their efforts.”
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The DOL proposal is a welcome corrective to the lack of balance and prescriptiveness of the 2020 rulemaking. It marks a return to the sound and neutral general principles DOL has articulated for years in its ERISA guidance on investing and proxy voting. And it eliminates the unwarranted and unsupported skepticism of the value of ESG considerations and proxy voting that pervaded the last rulemaking.
We encourage all interested clients and others to review the DOL’s proposal and add their voice to this important initiative. Comments can be submitted at the Federal eRulemaking Portal until December 13, 2021.