Department of Labor Proposes Regulations More Favorable to ESG-based Investment Decisions

Kramer Levin Naftalis & Frankel LLP

On Oct. 13, 2021, the U.S. Department of Labor (DOL) proposed amendments to its regulations (the Proposed Rule) that enhance the ability of employee benefit plan fiduciaries to consider climate change and other environmental, social and governance (ESG) factors in the investment of plan assets and the proxy voting of plan shares. The Proposed Rule would replace final regulations implemented by the DOL in 2020 (the Existing Regulations).

Background

The Employee Retirement Income Security Act of 1974, as amended, (ERISA) establishes minimum standards for the operation of private-sector employee benefit plans, including fiduciary responsibility rules that govern the investment of the assets of these plans. Whether, and to what extent, a fiduciary may consider collateral factors, such as climate change and ESG factors, in investment and proxy voting decisions has been the subject of DOL guidance since 1994 (and was addressed earlier in DOL advisory opinions). Prior to issuing the Existing Regulations in 2020, the DOL issued nonregulatory guidance in 1994, 2008, 2015 and 2018. The guidance expressed varying levels of comfort with the consideration of such factors. For example, the 1994 and 2008 guidance only related to “tie-breaker” situations, where collateral or ESG factors are used to select between economically equivalent investments. The 2015 guidance stated that such factors could also affect an investment’s risk and return, while the 2018 guidance cautioned that a fiduciary “must not too readily treat ESG factors as economically relevant.”

The DOL issued the Existing Regulations in November 2020 (with respect to investment decisions) and December 2020 (with respect to proxy voting). The Existing Regulations limit investment and related decisions to “pecuniary factors” but permit the application of nonpecuniary factors in tie-breaker situations, when choosing among potential investments that cannot be distinguished solely based on pecuniary factors. The Existing Regulations require that a fiduciary document the basis for concluding that the applicable investment was a tie-breaker situation and the basis for the selection of the tie-breaking investment.

With respect to an individual-account plan that provides for participant-directed investments (as is common for 401(k) plans), the Existing Regulations provide that a fiduciary is not prohibited from including an investment fund, product or model portfolio as a designated investment alternative solely because it promotes, seeks or supports one or more nonpecuniary goals, provided that selection of the investment alternative is otherwise consistent with the fiduciary’s responsibilities. However, the Existing Regulations specifically prohibit designating a qualified default investment alternative (QDIA) that includes, considers or indicates the use of one or more nonpecuniary factors in its investment objectives or goals or principal investment strategies.

Proposed Rule

On March 10, 2021, the DOL issued a policy statement announcing that the DOL would not enforce the Existing Regulations and was commencing a review of the Existing Regulations. This review culminated in the issuance of the Proposed Rule, which differs from the Existing Regulations in both tone and substance. The DOL noted in the preamble to the Proposed Rule that the Existing Regulations “had a chilling effect on appropriate integration of material climate change and other ESG factors in investment decisions.” Ali Khawar, acting assistant secretary for the DOL’s Employee Benefits Security Administration stated that “[a] principal idea underlying the [Proposed Rule] is that climate change and other ESG factors can be financially material and, when they are, considering them will inevitably lead to better long-term risk-adjusted returns, protecting the retirement savings of America’s workers.”

Investment Decisions

While the Proposed Rule retains the basic requirement that a fiduciary must be guided by “the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan,” the Proposed Rule includes several significant changes from the Existing Regulations:

  • Consideration of climate change and ESG factors. Several provisions of the Proposed Rule all but require the consideration of climate change and ESG factors when analyzing the projected return of a potential investment, stating that consideration of an investment’s projected return “may often require an evaluation of the economic effects of climate change and other [ESG] factors.” In addition, the Proposed Rule states that “the positive or negative effect of Government regulations and policies to mitigate climate change” may be material to a risk return analysis.
  • Tie-breaker definition. The Proposed Rule revised the rules regarding tie-breaker situations. The Existing Regulations define a tie-breaker situation as one where “the plan fiduciary is unable to distinguish on the basis of pecuniary factors alone.” The DOL concluded that this standard could be interpreted too narrowly, and the Proposed Rule instead refers to a situation in which the “competing investments, or competing investment courses of action, equally serve the financial interests of the plan.”
  • Tie-breaker documentation. The Existing Regulations obligate fiduciaries who utilize climate change and ESG factors as a tie-breaker to document the basis for the investment decision. The Proposed Rule deletes these requirements, but requires that the collateral-benefit characteristics of the applicable investment be disclosed to plan participants.
  • Individual-account plans. The Proposed Rule eliminates the Existing Regulations’ prohibition on designating a QDIA that includes, considers or indicates the use of one or more nonpecuniary factors in its investment objectives or goals or principal investment strategies.

Proxy voting

The Proposed Rule changed the Existing Regulations in several significant respects.

  • Consideration of climate change and ESG factors. While retaining the basic principle that a fiduciary’s decision with respect to the voting of shares held by the trust must be “solely in accordance with the economic interest of the plan and its participants and beneficiaries,” the Proposed Rule references the language applicable to investment decisions, thus including consideration of climate change and ESG factors with respect to voting decisions.
  • Requirement to vote proxies. The Existing Regulations state that a fiduciary need not vote every proxy or exercise every shareholder right. This statement is deleted in the Proposed Rule. While it is clear from both the preamble and text of the Proposed Rule that a fiduciary is not required to vote every proxy, the deletion of the specific statement likely will encourage fiduciaries to be more active with respect to voting proxies.
  • Record keeping. The Existing Regulations require fiduciaries to maintain records on proxy voting activities and to monitor the proxy voting activities of any investment managers to whom the authority to vote proxies has been delegated. This requirement is deleted in the Proposed Rule, although the DOL notes in the preamble to the Proposed Rule that this deletion is not intended to reflect a substantive change in a fiduciary’s obligation to properly monitor proxy voting activities.
  • Safe harbor. The Existing Regulations include two examples of proxy voting policies that act as safe harbors. The Proposed Rule does not include these safe harbors but solicits comments with respect to the safe harbors.

Conclusion

The DOL will not implement a final regulation until after the conclusion of the public comment period, which will end on Dec. 13, 2021. However, in the meantime, the DOL has stated that it will not enforce the Existing Regulations.

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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.

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