On Tuesday, June 23, 2020, the U.S. Department of Labor (the “Department”) proposed a rule intended to “provide clear regulatory guideposts for plan fiduciaries in light of recent trends involving environmental, social and governance (ESG) investing.” The new rule codifies the Department’s existing position that plan fiduciaries must select investments based on financial considerations, not on non-pecuniary objectives.
The Department foreshadowed this approach back in 2018 when it issued Interpretive Bulletin 2018-01, which stated that “[f]iduciaries must not too readily treat ESG factors as economically relevant to the particular investment choices at issue when making a decision,” and “the decision to favor [a] fiduciary’s own policy preferences in selecting an ESG-themed investment option . . . without regard to possibly different or competing views of plan participants and beneficiaries would raise questions about the fiduciary’s compliance with ERISA’s duty of loyalty.” The anticipated approach has now arrived in the proposed rule.
Historically, the Department’s guidance has emphasized that plan fiduciaries must focus on the plan’s financial returns and that the financial interests of plan participants and beneficiaries must be paramount. The Department’s guidance has already established that fiduciaries violate the Employee Retirement Income Security Act of 1974 (“ERISA”) if they accept reduced financial returns or greater risks in exchange for social, environmental, or other public policy goals. The new rule would codify the Departments existing guidance and make related amendments, as follows:
- Codify the Department’s existing position that ERISA requires plan fiduciaries to select investments and investment courses of action based on financial considerations;
- Expressly provide that, to be in compliance with their ERISA duties, fiduciaries cannot subordinate plan participants’ and beneficiaries’ financial interests under to non-pecuniary goals;
- Add a provision that requires fiduciaries to consider other available investments to meet their ERISA duties;
- Acknowledge that ESG factors can be pecuniary factors, but require that ESG factors present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories, including an assessment of potential risks and returns. The new rule also would add new investment analysis and documentation requirements for when fiduciaries are choosing between economically “indistinguishable” investments; and
- Add a provision on selecting designated investment alternatives for 401(k)-type plans, reiterating that ERISA duties apply to a fiduciary’s selection of an investment alternative to be offered to plan participants and beneficiaries in an individual account plan, and describing the requirements for selecting investment alternatives.
The Department’s press release regarding the proposed rule change quotes Secretary of Labor Eugene Scalia as stating that “[p]rivate employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan. Rather, ERISA plans should be managed with unwavering focus on a single, very important social goal: providing for the retirement security of American workers.”
The proposed rule change is an interesting development in the ESG and sustainable investing space, and it is both less and more important than it appears to be at first glance. Below are our takeaways:
Why the proposed rule change is less important than we might think:
- The proposed rule will likely not have any direct effect on a significant portion of ESG investment vehicles. ERISA is a federal law that governs the management and investment of U.S. private sector employee benefit and contribution plans. While ERISA may apply indirectly to other investment vehicles, it does not impose fiduciary duties on many investment advisors and managers who oversee billions, if not trillions, in ESG investments. Therefore, while the proposed rule, if adopted, will increase fiduciary pressure for U.S.-based benefit plan investors, it will not directly impose requirements on most external public investment vehicles, including mutual funds, ETFs, hedge funds, and REITs, or on alternative forms of private financing, including private equity and venture capital unless such investment vehicles are otherwise subject to fiduciary standards. Moreover, absent action by States, it will not apply to state-managed pension funds, such as CalPERS and CalSTERs, which are some of the largest public pension funds in the world, and two of the most influential shareholder bodies in the U.S.
- The proposed rule ignores studies indicating that a company’s increased focus on ESG matters correlates to higher returns. Although the proposed rule acknowledges that ESG factors may be pecuniary factors, it also essentially assumes that furthering environmentally or socially progressive goals is likely to be at odds with a plan’s financial interests. However, a growing body of research suggests the opposite. A 2015 Harvard Business School study of over 2,300 firms found that companies that commit to and invest in sustainability efforts have higher risk-adjusted stock performance, sales growth and margins, and numerous other studies since then have also supported the conclusion that there is a positive correlation between ESG and performance.
Why the proposed rule change is more important than we might think:
- While the proposed rule generally only directly affects U.S. plan fiduciaries, it might have an indirect ripple effect that could mean other ESG investments will have additional information hurdles. While, as mentioned above, the proposed rule would only directly impose additional duties for the fiduciaries of U.S. private sector employee benefit and contribution plans, there is the possibility that these fiduciaries will effectively pass some of the additional informational requirements on to those managing the investments they choose from. While the fiduciary duties themselves will stay with the plan fiduciaries, in making their choices among various investments, these fiduciaries may impose higher informational requirements on ESG investment vehicles and funds in order to enable the fiduciaries to meet their own duties. This could create a subtle, and some would say a much needed, shift in ESG investing and reporting, away from “window dressing” and “virtue signaling” and toward more concrete measurements and requirements.
- By essentially assuming that ESG factors are non-pecuniary and requiring that their pecuniary nature meet generally accepted investment theories, the proposed rule could inadvertently create support for integrated reporting. Ironically, the Department’s efforts to limit the use of ESG factors in investment decisions subject to ERISA could have the effect of increasing support for integrated reporting in the U.S. Considered by some to be the future of corporate reporting, integrated reporting efforts generally seek to capture nonfinancial values in financial terms and reports. In other words, they generally seek to incorporate nonfinancial information, including sustainability and ESG information, into traditional financial statements and reporting requirements. The ESG subcommittee of the SEC Asset Management Advisory Committee has acknowledged the need for a consistent framework in integrating ESG considerations into investment considerations. The more complex question is whether, and if so to what degree, the adoption of integrated reporting would effectively require U.S. companies to broaden the accepted definition of materiality. That is a bigger question for another day, but the proposed rule’s requirement that plan fiduciaries prove the pecuniary nature of ESG factors under generally accepted investment theories may actually have the effect of encouraging the closing of the gap in the U.S. between sustainability reporting and generally accepted accounting principles.
As always, we recommend that clients focus on building their ESG strategies organically, reflecting ESG concepts through operations, risk enterprise management processes, and procedures and compliance efforts instead of attempting to artificially attach ESG as an isolated effort. ESG risks and opportunities have always existed. The most successful companies focus on the content of those risks and opportunities rather than on the “ESG” label, and that will continue to be the case even if the Department moves forward with the rule change.