A new proposal would amend changes made to ERISA less than a year ago that have proved to be detrimental to ESG investing.
By Jean-Philippe Brisson, Paul A. Davies, Nicola Higgs, Malorie R. Medellin, and Deric Behar
In a sweeping reversal of Trump-era policies, the US Department of Labor (DOL) has issued a proposed rule, Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights (the Proposal), that would allow retirement savings plans to choose investments using analyses that incorporate climate change risks and other environmental, social, and governance (ESG) criteria.
The Proposal, if adopted, would amend the DOL rule Financial Factors in Selecting Plan Investments (the Rule), which was published in November 2020. The Rule adopted amendments to certain provisions of the “investment duties” regulation under Title I of the Employee Retirement Income Security Act of 1974, as amended (ERISA), and required fiduciaries of pension plans (and other benefit plans covered by ERISA) to choose investments “based solely on pecuniary factors” relevant to a particular investment. In effect, the Rule was premised on the idea that ESG factors are at odds with financial factors and fiduciary responsibilities of plan sponsors, and therefore plan fiduciaries should be restricted from making investment decisions based on ESG factors that are not primarily “pecuniary in nature” (see this Latham post for more information).
Although the Rule is still technically in effect, President Biden signed an Executive Order on his first day in office on January 20, 2021, ordering “all executive departments and agencies to immediately review and… take action to address the promulgation of Federal regulations and other actions during the last 4 years that conflict with these important national objectives [inter alia, to reduce greenhouse gas emissions and to bolster resilience to the impacts of climate change], and to immediately commence work to confront the climate crisis.”
Pending its review, the DOL announced on March 10, 2021, that it would not enforce the Rule.
In stark contrast to the Rule, the key idea underpinning the Proposal is that ESG factors can be financially material and directly related to the risk and reward analysis of investment decisions. Specifically, the Proposal would amend the “investment duties” regulation under ERISA (as it stands under the current Rule) to reflect the following:
Fiduciary Duty of Prudence
- Allows for the evaluation of the economic effects of climate change and other ESG factors in an investment analysis (and may even require the consideration of such factors when evaluating an investment’s risks and returns)
- Confirms that a fiduciary may consider any factor material to the risk-return analysis, including climate change and other ESG factors. Examples given in the Proposal include:
- A corporation’s exposure to real and potential economic effects of climate change
- Board composition, executive compensation, and transparency and accountability in corporate decision-making
- Workforce practices, including the corporation’s progress on diversity, inclusion, and other drivers of employee hiring, promotion, and retention
The Proposal would maintain language from the Rule requiring a fiduciary to consider how an investment or investment course of action compares to reasonably available alternative investments or investment courses of action. This provision, however, maintains general applicability and is not intended to target the use of ESG factors in selecting investments (according to the Proposal’s supplementary information).
Fiduciary Duty of Loyalty
- Eliminates the Rule’s use of the ambiguous term “pecuniary factors,” and confirms that consideration of all material factors is consistent with ERISA’s duty of loyalty
- Modifies the prohibitive “tie-breaker” standard in the Rule, so that if a fiduciary prudently concludes that competing investment choices equally serve the financial interests of the plan, a fiduciary can choose the investment based on collateral benefits other than investment returns
- Eliminates the Rule’s specific documentation requirements for tie-breaker cases that single out and create burdens for investments providing collateral benefits (which many perceive as targeting ESG investing for special scrutiny), while adding a new requirement that, for such choices, the collateral-benefit characteristics must be prominently displayed in disclosure materials provided to participants and beneficiaries
- Eliminates the Rule’s prohibition on the use of certain investment alternatives as a qualified default investment alternative (QDIA) if the fund, product, or model portfolio reflects non-pecuniary objectives; collateral-benefit characteristics of investment choices must also be prominently displayed in disclosure materials
- Emphasizes longstanding policy that a fiduciary may not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to other objectives, and may not sacrifice investment return or take on additional investment risk to promote goals unrelated to the plan and its participants and beneficiaries
The Proposal reflects the goals outlined by the Biden Administration’s January 2021 Executive Order on Tackling the Climate Crisis at Home and Abroad, May 2021 Executive Order on Climate-Related Financial Risk, and October 2021 Roadmap to Build a Climate-Resilient Economy that contribute to a “whole of government approach” to mitigating climate-related risks to the financial system on a domestic and global level. Indeed, the May 2021 Executive Order specifically called on the Secretary of Labor to publish “a proposed rule to suspend, revise, or rescind” the Rule.
The Proposal highlights that there is no substitute for sound and prudent investing practices by fiduciaries in ERISA plans. But rather than prohibit non-pecuniary factors, the Proposal sets forth a framework whereby plan managers are allowed leeway, within the parameters of the fiduciary laws, to consider climate and ESG criteria in the same light as other material risks. According to the Proposal, “climate change and other ESG factors are often material… in the assessment of investment risks and returns.” In short, the Proposal aims to benefit both plan beneficiaries and “society more broadly but without any detriment to the participants and beneficiaries in ERISA plans.”
The Proposal is open for public comment until December 13, 2021, 60 days from publication in the Federal Register.
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