November 29, 2022

Climate change applies to government too: DOL issues new final ESG regulations

Catherine Beaver, Adam Cohen, Carol McClarnon

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Eversheds Sutherland (US) LLP

On October 14, 2021, the US Department of Labor (DOL) proposed changes to ERISA regulations that would again shift the analysis of consideration of environmental, social, and governance (ESG) factors in retirement plans governed by ERISA. The proposal (2021 Proposal) reacted to the Trump Administration’s 2020 final regulations on ESG (2020 Regulations) by reversing course on key aspects of those regulations and offering several changes that may have been intended to facilitate ESG considerations by plan fiduciaries. The DOL finalized those regulations on November 22, 2021 (the Final Rule).

A Brief Review of ESG under ERISA
ERISA requires that fiduciaries must act “solely in the interest of participants and beneficiaries,” and in accordance with a specified standard of prudence and loyalty. All of the past DOL guidance on ESG has reiterated these principles, which remain at the center of fiduciary behavior. The question has been to what extent consideration of ESG factors could be consistent with these standards under ERISA.

Successive presidential administrations have attempted to clarify whether and to what extent fiduciaries can or should consider ESG factors in investment decisions. In general, Republican administrations have issued guidance that tended to raise the bar for consideration of ESG factors, while Democratic administrations have issued guidance that allowed somewhat more flexibility in considering ESG. This back-and-forth in sub-regulatory guidance led to the Trump Administration’s attempt to create a permanent rule through issuing regulations in 2020. Those regulations included a number of provisions perceived as limiting the ability of fiduciaries to consider ESG.

The Biden administration dispensed with the notion that putting ESG rules in the form of regulations would end the political back-and-forth. Shortly after the inauguration, in response to an executive order, the DOL issued a non-enforcement policy with regard to the 2020 Regulations. Later in 2021, the DOL issued a new set of proposed regulations that would change key aspects of the 2020 Regulations, in each case removing perceived barriers to consideration of ESG factors.

The Final Rule

The underlying themes of the Final Rule are to remove the perceived barriers of the 2020 Regulations and allow fiduciaries to both protect participants by mitigating investment risks associated with ESG factors and to ensure that participants have access to prudent and attractive investment opportunities. The Final Rule largely follows the 2021 Proposal with some clarifications. The chart below summarizes the most significant changes of the 2021 Proposal and any modifications to these provisions in the Final Rule.

Topic	2021 Proposal	2022 Final Rule
Standard for consideration of ESG factors	Included controversial language specifying that, to meet the duty of prudence, a fiduciary’s consideration of a projected return in connection with an investment “may often require” an evaluation of the effects of climate change and other ESG factors on the investment.	Removed the “may often require” language and clarified that, to meet the duty of prudence, a fiduciary must base investment decisions on all factors that the fiduciary reasonably determines are relevant to the projected return in connection with an investment. The regulations state that this may include effects of climate change and other ESG factors.
Examples of potentially permissible ESG factors	Added a new paragraph clarifying that a fiduciary may, depending on the circumstances, consider climate change and other ESG factors as material factors in its risk-return analysis and provided the following examples: Climate change-related factors, such as a corporation’s exposure to the real and potential economic effects of climate change, and the effect of government regulations and policies; Governance factors, such as board composition, executive compensation, and compliance with laws and regulations; and Workforce practices, including diversity, equity, and inclusion and labor relations.	In response to comments to the DOL on whether it would be helpful to have other or fewer examples of factors fiduciaries may consider in evaluating investment alternatives, the DOL removed the examples from the final regulation. The DOL noted that it does not want the appearance of regulatory bias in favor of particular investments or investment strategies.
QDIA and ESG	Eliminated the Trump Administration’s special rule prohibiting ESG funds from serving as a QDIA and applied the same fiduciary standards with regard to selection and monitoring of a QDIA as those applicable to other designated investment alternatives, including consideration of climate change and other ESG factors.	DOL adopted the 2021 Proposal of revoking the Trump Administration’s rule, thus applying the same standards to investments with an ESG focus as other investments for purposes of selecting the QDIA.
Tie-breaker for comparable investments	Reverted to the DOL’s historical tie-breaker standard, making clear that a fiduciary is not prohibited from selecting an investment based on collateral benefits other than investment returns, so long as the fiduciary prudently concludes that the proposed investment and competing investment alternatives “equally serve the financial interests of the plan.” Also, for participant-directed individual account plans, required prominent disclosure of the collateral benefit if the investment was selected based on the tie-breaker rule.	DOL requested comments on whether the tie-breaker approach is sufficiently clear and appropriate in light of the investment practices and strategies used by plan fiduciaries (and whether other approaches might better reflect plan practices). The Final Rule adopts the proposed tie-breaker rule. However, in response to comments that the disclosure requirement would be confusing and duplicative with existing disclosure, the Final Rule eliminates that requirement.
Proxy voting rules	Removed statements suggesting that it may be prudent not to vote proxies, reverting to the former more general fiduciary standard.	DOL adopted the 2021 Proposal of removing statements suggesting it may be prudent to not vote proxies.
Participant preferences	N/A	In response to comments seeking clarification, DOL added a provision to the regulations indicating that fiduciaries do not violate their duty of loyalty by taking into account participants' preferences when constructing a menu of prudent investment options for participant-directed individual account plans. However, the preferred investments must still satisfy the prudence requirements articulated in the Final Rule and other DOL guidance and case law.
ESsentials: By deleting the “may often require” language, DOL confirms that consideration of ESG factors is not a mandate. Nevertheless, it is clear that DOL views E, S and G components as having the potential to be economically significant factors that may form part of a prudent evaluation of risk and return.
ESsentials:. As with the 2021 Proposal, the Final Rule achieves its goals in large part by deleting the pecuniary / non-pecuniary distinction and replacing it with a standard that permits a fiduciary to consider any factor that a fiduciary reasonably determines is relevant to the risk and return characteristics of the investment. This represents a welcome return to the long-standing and proper ERISA principle that fiduciary decision-making should be evaluated by the prudence of the process.
ESsentials: The Final Rule’s tie-breaker standard realigns the rule more closely with the standard first articulated by DOL in Interpretive Bulletin 94-1, during the Clinton Administration. It permits fiduciaries to select plan investments based on economic or non-economic benefits other than investment returns so long as prudence and loyalty obligations are met, and the fiduciary does not sacrifice returns or accept additional risk to obtain the collateral benefits. The threshold test that competing investments must “equally serve” the plan’s financial interests appears to be a more flexible standard than provided in previous iterations of DOL guidance, but the proposed standard will present interpretive challenges of its own.
ESsentials: One of the more interesting aspects of the Final Rule is the focus on proxy voting and shareholders rights. The 2020 Regulations at least in tone suggested that fiduciaries often should not be voting proxies. The Final Rule flips that notion and seems to indicate that in some situations at least, fiduciaries may be required to exercise shareholder rights when that is necessary to protect participants’ interests.

The Final Rule is effective 60 days after publication in the Federal Register, except that the proxy voting changes are effective one year after publication in the Federal Register.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.