US Regulator Shifts Toward Favorable View on ESG Investing and the Exercise of Shareholder Rights in New Regulation

On October 14, 2021, the U.S. Department of Labor (the “DOL”) published a proposed regulation entitled “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights” (the “Proposed Rule”).  The Proposed Rule is the latest in a series of DOL guidance and regulations regarding a plan fiduciary’s consideration of environmental, social and governance (“ESG”) factors when making investment decisions for ERISA plans and the exercise of shareholder rights by such plans. The Proposed Rule follows prior regulations issued by the DOL under President Trump in 2020 regarding both ESG (the “2020 ESG Rule”) and proxy voting (the “2020 Proxy Rule,” together with the 2020 ESG Rule, the “2020 Rules”). The 2020 Rules themselves followed a series of sub-regulatory guidance by the DOL, which issued guidance on these topics under each of the Clinton[1], Bush[2], Obama[3] and Trump[4] administrations. While the bedrock principals under the guidance largely remained unchanged, the gloss and tenor of the guidance has shifted, depending upon the political views of the White House’s then-current occupant.

ESG investing is increasingly popular and the importance that the Biden administration places on the topic is evident. In fact, on President Biden’s first day in office, he signed an executive order which included a fact sheet directing the DOL to review the 2020 ESG Rule. On March 10, 2021 the DOL released a policy statement that it will not enforce or otherwise pursue enforcement actions against a fiduciary for failing to comply with the 2020 Rules. On May 20, 2021, President Biden issued another executive order which specifically directed the DOL to consider publishing a proposed rule to suspend, revise or rescind the 2020 Rules.

In the Proposed Rule, the DOL stated that pursuant to the executive orders mentioned above, the DOL reached out to several “stakeholders” regarding the 2020 Rules, including “asset managers, labor organizations and other plan sponsors, consumer groups, service providers and investment advisers.” The DOL stated that these stakeholders suggested that the 2020 Rules may have led to additional investor confusion, rather than clarification. In particular, the DOL determined that certain statements in the preamble to the 2020 ESG Rule (cautioning fiduciaries from “too hastily” concluding that ESG funds should be selected based on pecuniary factors) may have had a “chilling effect” on the integration of financial ESG factors into plans’ investment decisions.  Similarly, the DOL expressed concern that the 2020 Proxy Rule has caused a misconception that fiduciaries could generally refrain from voting proxies and exercising shareholder rights, even if exercising such rights would be in the plan’s best interest.

ESG Investing

The 2020 ESG Rule, as originally proposed, singled-out ESG considerations for additional scrutiny and generated a great deal of controversy from plan sponsors and investment professionals alike. In the final version of the 2020 ESG Rule, the DOL deleted all references to the term “ESG” and focused on whether an investment factor was “pecuniary” or “non-pecuniary.” The 2020 ESG Rule required a fiduciary to base its investment decisions solely on pecuniary factors, unless the fiduciary was unable to distinguish between multiple investments based on such pecuniary factors. The 2020 ESG Rule also prohibits selecting an investment option as a QDIA[5] if the investment option’s objectives, goals or principal investment strategies consider non-pecuniary factors, even if the selection of such investment is based solely on pecuniary considerations.

Similar to the 2020 ESG Rule, the Proposed Rule states that a prudent analysis of an investment requires a fiduciary to consider, among other things, the projected return of the plan’s portfolio (or the portion thereof with respect to which it has investment duties) relative to the plan’s funding objectives. However, the Proposed Rule adds that such an analysis “may often” necessitate consideration of the economic effects of climate change and other ESG factors. While the 2020 ESG Rule also allowed for the consideration of “pecuniary” ESG factors, the Proposed Rule appears to go one step further in requiring the consideration of relevant economic ESG factors and noting that such factors are commonly present.

In addition, the Proposed Rule states that when evaluating an investment or investment course of action, a prudent fiduciary may consider any factor which is material to the risk-return analysis and includes several examples of such factors which relate to ESG: (1) climate-change related factors, including both the direct effects of climate-change on a corporation and risks associated with government regulations intended to moderate climate change; (2) governance factors, such as board composition, accountability and transparency, as well as a corporation’s compliance with applicable laws and (3) workforce practices, including diversity, retention and training practices. The DOL explained in the preamble these examples are intended to clarify that economic ESG factors should be treated no differently than “other ‘traditional’ material risk-return factors.”

The Proposed Rule is also more permissive in allowing the use of collateral (i.e., non-economic) ESG factors as a “tie-breaker.” The 2020 ESG Rule expressed skepticism over the tie–breaker test and restricted the use of collateral ESG factors to scenarios where the fiduciary is unable to distinguish between multiple investment options based on pecuniary factors alone and the fiduciary documents the use of such collateral factors. The Proposed Rule uses a more permissive standard for determining when a “tie” occurs. The rule allows a fiduciary to use collateral factors as a tie-breaker if the investments “equally serve the financial interests of the plan over the appropriate time horizon.” This allows for collateral factors to be used if different investments are economically distinguishable, yet equally appropriate for the plan’s investment portfolio. The DOL did not include any restrictions on the kinds of collateral ESG factors that could be used to “break the tie,” but solicited comments on whether to include such limitations (e.g., only allowing the use of factors that are appropriate based on an assessment of the shared interests or views of plan participants).

The Proposed Rule also does not require that the use of collateral factors as a tie-breaker be documented. As explained in the preamble, the DOL determined that such a requirement may have a chilling effect on the use of collateral ESG factors in appropriate circumstances. However, the DOL notes that fiduciaries are already subject to a prudence standard and maintain records regarding their investment decisions accordingly. As such, fiduciaries may need to continue to document their use of collateral factors as a matter of prudence.

Collateral ESG factors can also be used as a tie-breaker between investments when selecting designated investment options for a participant-directed plan (e.g., a 401(k) plan) but the nature of such collateral benefits must be “prominently displayed in disclosure materials.” In the preamble, the DOL describes that this requirement is intended to allow plan participants who may not share the same preference for a given collateral purpose to be aware of the nature of the investment. The DOL indicated that it views the plan’s 404a-5 disclosure as the likely location for this disclosure.

Finally, the Proposed Rule allows for a fund to be chosen as a QDIA despite its consideration of collateral ESG factors, if the choice of such fund as a QDIA is financially prudent and otherwise meets the QDIA regulations.[6]

Proxy Voting

The Proposed Rule reaffirms the DOL’s longstanding view that an ERISA fiduciary’s duties extend to the management of shareholder rights relating to shares of stock that are plan assets. The Proposed Rule removes a statement included the 2020 Proxy Rule that “the fiduciary duty to manage shareholder rights appurtenant to shares of stock does not require the voting of every proxy or the exercise of every shareholder right.” In the Proposed Rule’s preamble, the DOL expressed that this was due to a concern that fiduciaries will misconstrue this statement as allowing them to abstain from voting plan proxies without proper consideration of the benefits to exercising such rights. However, the DOL cautions that the removal of this statement should not be read as requiring fiduciaries to always vote proxies. Rather, the DOL’s view is that proxies should be voted unless a fiduciary determines that voting the proxy would not be in the plan’s best interest (e.g. due to the prohibitive cost involved).

Unchanged from the 2020 Proxy Rule are the requirements that when a fiduciary is considering whether and how to exercise a plan’s shareholder rights, it must (1) act solely in accordance with the economic interests of plan participants and beneficiaries and not subordinate the financial interests of participants and their beneficiaries to any other objective; (2) consider relevant costs involved in exercising shareholder rights; (3) evaluate material facts that form the basis for the proxy vote or exercise of shareholder rights; and (4) exercise prudence and diligence in the selection and monitoring of service providers that exercise or otherwise assist with the exercise of shareholder rights. A fiduciary is also prohibited from following a proxy adviser’s recommendations without determining that such adviser’s guidelines are consistent with those described above. The Proposed Rule deletes a provision from the 2020 Proxy Rule which set out specific obligations to monitor an investment manager or proxy firm that has been delegated authority to exercise shareholder rights, but the preamble clarifies that this is not intended to be a substantive change. Rather, the DOL views this as included within the requirement to exercise prudence and diligence in selecting and monitoring proxy-related service providers.

The Proposed Rule allows fiduciaries to establish guidelines to assist in deciding whether to vote on a given proxy proposal, provided that such policies are prudently designed to provide benefits to plan participants and beneficiaries and defray reasonable administrative expenses. Plan fiduciaries must periodically review[7] such policies. Unlike the 2020 Proxy Rule, the Proposed Rule does not include any safe harbor sample policies. In the preamble, the Proposed Rule states that the DOL lacks confidence that the 2020 Proxy Rule’s safe harbor examples are necessary or helpful, but the DOL solicited comments on this point. The Proposed Rule (just like the 2020 ESG Rule) states that a fiduciary can always override a plan’s proxy voting policy in a particular instance if it determines that deviating from the voting policy would be in the best interests of the plan.

Another significant change from the 2020 Proxy Rule is the elimination of the requirement that plan fiduciaries maintain records on proxy voting and other shareholder rights. The preamble explains the DOL believes that such a documentation requirement could lead fiduciaries to think that exercising shareholder rights is disfavored or carries grater fiduciary obligations, causing fiduciaries to refrain from exercising such rights.

The Proposed Rule also provides (substantially unchanged from the 2020 Proxy Rule and prior guidance) that the responsibility for exercising shareholder rights lies with the plan’s trustee unless it is subject to the directions of a named fiduciary or discretion over relevant assets has been properly delegated to an investment manager. When authority over assets has been delegated to an investment manager, the manager has exclusive authority to exercise shareholder rights appurtenant to those assets unless the plan, trust document or investment management agreement expressly provides that another fiduciary has the right to direct the plan trustee regarding the exercise of any such rights. Moreover, when a pooled investment vehicle is subject to ERISA and several ERISA investors in the vehicle have investment policy statements that conflict with one another, the investment manager must attempt to reconcile the different policies (assuming such policies are in compliance with ERISA). With respect to proxy voting, the investment manager must vote proxies in proportion with each relevant plan’s interest in the pooled investment vehicle. Alternatively, an investment manager may require participating plans to review and approve of the investment manager’s proxy voting policy prior to investing, in which case the investing fiduciary must ensure that the investment manager’s policy is consistent with Title I of ERISA and the Proposed Rule. The Proposed Rule clarifies that it does not apply to voting, tender and similar rights related to securities that pass through such rights to participants and beneficiaries of an individual account plan. In such a case, the plan trustee would be obligated to follow the direction of participants (assuming the directions are made in accordance with the plan terms and ERISA).

In addition to several items listed above, the Proposed Rule solicits comments on a number of concepts, including:

• Whether fiduciaries should consider climate change as presumptively material, and if so, the proper evidentiary basis to rebut such a presumption;
• The standard for when collateral factors can be used as a tie-breaker (i.e., the investment options “equally serve the financial interests of the plan”);
• Whether the DOL should use additional or other examples than the climate change, governance and HR factors listed in the Proposed Rule when describing factors that are material to a risk-return analysis;
• The utility of the disclosure requirement when a collateral factor is used as a tie-breaker in selecting a QDIA;
• Whether to continue to include specific language cautioning a fiduciary from adopting the practice of always following a proxy adviser’s recommendations, given the general requirement to use prudence and diligence in selecting and monitoring such persons;

Comments to the Proposed Rule must be submitted on or before December 13, 2021.

Takeaways

The DOL under President Biden is clearly telegraphing that it views ESG as an important issue for a plan fiduciary to consider when making investment decisions. Plan fiduciaries should prepare to incorporate an economic ESG analysis as part of their investment-making decision process, to the extent they are not doing so already. Nevertheless, it is important to note that the Proposed Rule does not go so far as to allow fiduciaries to utilize collateral ESG factors at the expense of the plan’s economic considerations. Depending on the comments the DOL receives, the final rule could provide even more specific guidance on when it would be appropriate or recommended for plans to invest in ESG-themed funds. Fiduciaries should also prepare to ensure that proxies are generally voted and other shareholder rights exercised, unless it determines that the exercise of such rights would not be in the plan’s best interest.

[1] Interpretive Bulletin 94-1 59 FR 32606 (June 23, 1994) and Interpretive Bulletin 94-2 (IB 94-2) and 59 FR 38860 (July 29, 1994)

[2] Interpretive Bulletin 2008-01 73 FR 61734 (Oct. 17, 2008) and Interpretive Bulletin 2008-02 73 FR 61731 (Oct. 17, 2008)

[3] Interpretive Bulletin 2015-01, 80 FR 65135 (Oct. 26, 2015) and Interpretive Bulletin 2016-01, 81 FR 95879 (Dec. 29, 2016)

[4] Field Assistance Bulletin 2018-01 (FAB 2018-01)

[5] QDIAs are default investment options for participants who have not made their own investment choice. ERISA regulations provide a “safe harbor” for a fiduciary’s selection of the investment option if certain conditions are met.

[6] 29 CFR 2550.404c-5

[7] The DOL explained with respect to identical language in the 2020 Proxy Rule that it expects fiduciaries to conduct such a review “roughly” every two years, but it did not want to create an exact timeline to avoid violations based on technicalities.

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