The U.S. Department of Labor (DOL) released Proposed Regulations for plan fiduciaries on the role Environmental, Social, and Governance (ESG) considerations should play in investment decisions.
The Proposed Regulations:
- include language intended to counteract the negative perception of the use of climate change and other ESG factors in investment decisions caused by the 2020 ESG regulations;
- clarify that a fiduciary’s duty of prudence may often require an evaluation of the economic effects of climate change and other ESG factors; and
- provide examples of how ESG concerns may be material to the fiduciary’s risk-return analysis involved in selecting plan investments.
The Bottom Line
The DOL has long attempted to provide ESG guidance to plan fiduciaries. While the specifics of the DOL guidance has varied, the basic requirement—which is reiterated in the new Proposed Regulations—is that a fiduciary must consider risk and return factors that are material to an investment’s value.
The U.S. Department of Labor (DOL) released a new set of Proposed Regulations that (again) seek to define the extent to which a plan fiduciary may take into account Environmental, Social, and Governance (ESG) factors in investing plan assets. The Proposed Regulations also address a plan fiduciary’s duty to manage shareholder rights appurtenant to investments in shares of stock, such as proxy voting.
Over the past three decades, the DOL has attempted to provide guidance to plan fiduciaries as to when and how they can consider ESG factors in making investment decisions. While the tone and tenor of the DOL guidance has varied, the basic requirement – which is reiterated in the new Proposed Regulations – is that a fiduciary must consider risk and return factors that are material to an investment’s value.
As we reported in 2020, the DOL in the last year of the Trump administration proposed and later finalized ESG investing rules for plan fiduciaries. In describing the prior 2020 ESG regulations, the DOL expressed concern that they created a perception that plan fiduciaries are at risk if they include any ESG factors in the financial evaluation of plan investments. In March 2021, the DOL announced that it was reexamining its 2020 ESG regulations, and that it would not enforce the 2020 ESG regulations against plan fiduciaries.
Proposed Changes to Clarify Permissibility of Consideration of ESG Factors
The Proposed Regulations add language intended to counteract the negative perception of the use of climate change and other ESG factors in investment decisions caused by the 2020 ESG regulations, and clarify that a fiduciary’s duty of prudence may often require an evaluation of the economic effects of climate change and other ESG factors.
The Proposed Regulations provide examples of how ESG concerns may be material to the fiduciary’s risk-return analysis involved in selecting plan investments. Those include:
- Climate-change related factors, such as a company’s exposure to the physical risks of climate change (including the significant economic consequences on businesses as more extreme weather conditions damage physical assets, disrupt productivity and supply chains, and force adjustments to operations), and the effect of government regulations and policies to mitigate climate change.
- Governance factors, such as those involving board composition, executive compensation, and transparency and accountability in company decision-making, as well as a company’s avoidance of criminal liability and compliance with labor, employment, environmental, tax, and other applicable laws and regulations.
- Workforce practices, including a company’s progress on workforce diversity, inclusion, and other drivers of employee hiring, promotion, and retention; its investment in training to develop its workforce’s skill; equal employment opportunity; and labor relations.
Changes to Qualified Default Investment Alternative (QDIA) Provisions
The 2020 ESG regulations prohibit a fund from serving as a QDIA if it, or any of its component funds, has investment objectives, goals, or principal investment strategies that consider the use of non-financial factors, even if the fund is objectively economically prudent from a risk/return perspective. The Proposed Regulations eliminate this prohibition and provide that if a fund expressly considers climate change or other ESG factors, is financially prudent, and meets the protective standards set out in the DOL’s QDIA regulation, the plan fiduciaries may consider the fund as a QDIA.
Changes to the Tie-Breaker Test
The 2020 ESG regulations contain the so-called “tie-breaker” standard, which first appeared in DOL sub-regulatory guidance from the 1990s. Under the tie-breaker standard, if a fiduciary has determined that two investment options are indistinguishable based on the consideration of risk and return, the fiduciary can consider “non-pecuniary” factors, such as ESG goals, to break the tie. In the Proposed Regulations, the DOL expands the tie-breaker scenario such that the two investment options do not have to be indistinguishable before collateral benefits (including both ESG and non-ESG factors, such as community-based job creation) other than investment returns may be considered. Instead, the Proposed Regulations require fiduciaries to first establish that the two investment options “equally serve the financial interests of the plan” before collateral benefits are weighed. In such a case, the plan fiduciary must ensure that the collateral benefit characteristic of the fund is prominently displayed in disclosure materials to plan participants and beneficiaries.
Elimination of the Fiduciary Documentation Requirement
The Proposed Regulations also would remove the requirement in the 2020 ESG regulations for a plan fiduciary to document specially its analysis in those tie-breaker cases where the plan fiduciary has concluded that pecuniary factors alone were insufficient to be the deciding factor.
Changes to Provisions on Shareholder Rights/Proxy Voting Provisions
The Proposed Regulations would make several notable changes to the 2020 ESG regulation provisions on shareholder rights, including proxy voting.
Specifically, the Proposed Regulations would:
- Remove a statement indicating that a fiduciary is not required to vote all proxies. The DOL noted that fiduciaries are not required to always vote proxies or engage in shareholder activism. Rather, fiduciaries should take steps to ensure that the cost and effort associated with voting a proxy is commensurate with the significance of an issue to the plan’s financial interests.
- Eliminate a provision that prescribes specific monitoring obligations where the authority to vote proxies or exercise shareholder rights has been delegated to an investment manager (or a proxy voting firm). This proposed change stems from the DOL’s concern that the specific provision in the 2020 ESG regulations may be misinterpreted as requiring special obligations above and beyond the statutory obligations of ERISA.
- Remove the two “safe harbor” examples of permissible proxy voting policies. One of these safe harbors permits a fiduciary to implement a policy limiting voting resources to particular types of proposals that the fiduciary has prudently determined will materially affect the value of the investment. The other safe harbor permits a policy of refraining from voting on certain investment choices. The DOL indicated that these safe harbors may be misconstrued as regulatory permission for plans to abstain broadly from proxy voting without properly considering their interests as shareholders.
- Eliminate the requirement that, when exercising shareholder rights, plan fiduciaries must maintain records on proxy voting activities. The DOL views this provision as treating proxy voting differently from other fiduciary activities.
The comment period on the Proposed Regulations is set for 60 days from the October 14, 2021, date of publication in the Federal Register.
Ballard Spahr attorneys in the Employee Benefits and Executive Compensation Group are closely monitoring the Proposed Regulations and will advise plan sponsors and plan fiduciaries on their duties under ERISA.