On June 30, 2020, the US Department of Labor (DOL) published in the Federal Register a proposed rule that would regulate ERISA plan fiduciary conduct when considering investments under an environmental, social and governance (ESG) filter or, more generally, economically targeted investments (ETI). It also posted a news release and fact sheet providing background on and summarizing the proposal. In light of accelerating ESG interest among investors including retirement investors – for example, US sustainable funds attracted new assets at a record pace in 2019 – DOL is concerned that “some investment products may be marketed to ERISA fiduciaries on the basis of purported [ESG] benefits and goals unrelated to financial performance”, which raises “heightened concerns” given ERISA’s duty of loyalty that fiduciaries operate plans for the exclusive purpose of providing plan benefits to participants and beneficiaries.
As a formal matter, the proposal would incorporate three new principles into the existing ERISA regulation articulating a fiduciary’s investment duties (adopted in 1979 to endorse modern portfolio theory and not amended since) that would require the fiduciary:
- To evaluate “investments and investment courses of action based solely on pecuniary factors [a newly defined term] that have a material effect on the return and risk of an investment based on appropriate investment horizons and the plan’s articulated funding and investment objectives” as consistent with ERISA;
- Not to “[subordinate] the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to unrelated objectives, or [sacrifice] investment return or [take] on additional investment risk to promote goals unrelated to those financial interests of the plan’s participants and beneficiaries or the purposes of the plan”; and
- Not to “otherwise [act] to subordinate the interests of the participants and beneficiaries to the fiduciary’s or another’s interests and has otherwise complied with the duty of loyalty.”
The proposal goes on to provide that ESG factors are pecuniary factors only if “they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories …,” which fiduciaries must then weigh against other alternative investments. If the available investments are indistinguishable on this basis (which DOL expects would be a rare occurrence), then a non-pecuniary ESG or other factor may be used as the decisive criterion provided that the fiduciary documents “specify why the investments were determined to be indistinguishable and … why the selected investment was chosen based on the purposes of the plan, diversification of investments, and the interests of plan participants and beneficiaries in receiving benefits from the plan.”
The proposal also addresses specifically the selection of investment options for defined contribution plans, allowing the investment menu to include options with an ESG mandate or name provided that:
- The fiduciary use only “objective risk-return criteria” in selecting and monitoring the investment options, and documents that process; and
- The ESG option is not the qualified default investment alternative.
Comments on the proposal are due on July 30, 2020. The proposal would take effect 60 days after adoption, subject to any transition relief developed for the final rule.
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Eversheds Sutherland Observations:
- As we have previously documented, the proper role of ESG investing in ERISA plans has been the subject of debate between Democratic and Republican Administrations starting with the Carter Administration. This debate both mirrors and channels the ongoing debate in broader investment, corporate governance and political circles about shareholder activism and ESG investing generally. During Republican Administrations, DOL has opined that conventional investment factors are paramount for ERISA fiduciaries who may use ESG factors only as tie-breakers, while during Democratic Administrations DOL has suggested there may be more latitude for fiduciaries to take account of ESG factors at the margin. This debate has played out entirely in sub-regulatory guidance. By now proposing a regulation adopting the view of the current Administration, DOL effectively is bidding to preempt this policy debate across future Administrations, absent another rulemaking or legislation. Regardless of the policy outcome, it would be well for DOL to have a position on this issue on which plan fiduciaries and asset managers can rely for longer than the current Presidential election cycle.
- While we take DOL at its word that it has encountered ESG investment products promoted primarily for their non-pecuniary impact, the market has in at least some respects moved past this policy debate. Asset managers have brought to the market certain products reflecting one or more ESG factors and constructed around the thesis that these products will outperform other investments in their asset category, and have developed research and other materials in support of that thesis. There is, of course, an ongoing argument in the investment community whether that thesis and its underlying support will stand up, but in principle this approach to ESG investing seems responsive to either policy position under ERISA. Firms offering ESG products in the retirement market will no doubt evaluate their investment mandates and materials against the details of the proposed regulation, to be clear they are providing plan fiduciaries with an appropriate basis for considering those products.
- We do find DOL’s concern over the marketing of ESG products somewhat curious. Good fiduciary practice focuses on the substance of an investment opportunity, and not on any puffery in the marketing pitch.
- While it continues to be the case that ESG investing by ERISA plans has generally not proven to be controversial in actual practice, with very little litigation experience to date, investigations into ESG investing by specific plans and investment firms are in progress in various DOL Regional Offices including the New York Regional Office (reportedly independent of this regulatory initiative).
- There are interesting differences between US and European regulatory approaches to ESG investing, which we look forward to addressing separately.
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