On June 22, 2020, the United States Department of Labor (the "DOL") submitted a proposed regulation (the "Proposal") regarding the use of Environmental, Social and Governance ("ESG") factors in selecting investments for plans subject to the Employee Retirement Income Security Act of 1974, as amended ("ERISA"). The Proposal generally cautions plan fiduciaries against considering ESG factors when making investment decisions, unless such factors are relevant to the plan's pecuniary goals.
Interest in ESG-themed investments has surged in popularity in recent years. One 2020 survey showed that nearly 74% of global investors intend to increase their allocation to ESG-oriented ETFs. However, ESG-themed investments have also captured the attention of regulators, including the DOL. The Securities and Exchange Commission recently listed ESG investments in its list of examination priorities with respect to the accuracy and adequacy of disclosures in the marketing of such investments. In addition, President Trump issued an Executive Order on April 10, 2019, which included a section on ESG investments. The Executive Order required the DOL Secretary to complete a review of trends with respect to ERISA plan investment in the energy sector.
In the Proposal, the DOL emphasizes that when an ERISA fiduciary uses ESG factors to guide its investment choices, it must avoid placing its own social and public policy goals ahead of the financial interests of plan participants. The Proposal follows a 2018 Field Assistance Bulletin ("FAB") and a series of Interpretative Bulletins (IBs) issued by the DOL on this topic over the years, beginning in 1994. While the FAB and each IB purported to be consistent with the DOL's prior guidance regarding ESG factors, the tenor and details of the guidance often shifted based on the political orientation of the then-current administration. While the Proposal mostly follows guidance issued in its recent FAB, it poses additional documentation requirements on plan fiduciaries in certain situations. Moreover, Field Assistance Bulletins and IBs are informal, non-binding guidance issued by the DOL which can be modified with relative ease. Conversely, a regulation like the Proposal must undergo public notice and comment and would be more difficult to overturn if finalized.
Much like the FAB, the Proposal differentiates between "pecuniary" ESG factors which present additional business risks or opportunities that affect the economics of the investment based on "generally accepted investment theories" and "collateral" ESG factors which may promote a favorable public policy or practice, but have little to no relevance on investment risk or return. The Proposal generally allows for the consideration of pecuniary ESG factors and provides two examples of such factors: (i) a company's improper waste disposal, which could pose the threat of additional liabilities, regulatory risk and litigation and (ii) a company's "dysfunctional" improper governance. Despite the permissibility and perhaps, advisability, of a fiduciary's consideration of pecuniary ESG factors, the Proposal warns that a fiduciary must not afford outsize weight to such factors when considered alongside other relevant pecuniary factors.
On the other hand, the Proposal generally disfavors "collateral" ESG factors and only allows the use of such public policy, political or other non-pecuniary factors as a theoretical "tie-breaker" when deciding between multiple economically indistinguishable investment options. The Proposal states that the DOL's expectation is that such draws between two investment options "rarely, if ever, occur," though the Proposal requests comment on the frequency of such "ties." Moreover, the Proposal requires that when a fiduciary wishes to use collateral ESG factors as a tie-breaker, the fiduciary must document the basis for concluding that such investment options are indistinguishable. The fiduciary must also document the basis for concluding that the investment option was chosen based on the purposes of the plan, the diversification of its investments and the interests of plan participants and beneficiaries.
When including an ESG-themed investment as a designated investment option in an individual account plan (such as a 401(k) plan), the Proposal reiterates that the selection of the investment must be based on "objective risk-return criteria" (e.g., expense ratios, fund size, volatility measures and the investment philosophy and experience of the relevant investment manager). While a fiduciary can ultimately select an ESG-themed investment if it meets such criteria, the Proposal requires that the fiduciary document its selection and monitoring of the investment in accordance with such criteria. Further, the Proposal disallows selecting an ESG-oriented investment as a qualified default investment alternative ("QDIA")1 for a participant-directed defined contribution plan under any circumstances - even if such an investment option were selected solely on the basis of objective risk-return criteria.
The Proposal would also add to the original "investment duties" regulations that describe the fiduciary duties of prudence and exclusive purpose under Section 404(a) of ERISA as they relate to plan investments.2 Current regulations already require that when a plan fiduciary analyzes any investment, it must consider how the investment relates to the plan's diversification, cash flow and funding requirements. The Proposal adds that the fiduciary must specifically compare how the relevant investment compares to other investments with regard to such factors. In addition, the Proposal states that in order for a fiduciary to comply with ERISA's prudence standard of care when making investment decisions, it must: (i) evaluate the investment based solely on pecuniary factors that have a material effect on the risk and return of an investment based on appropriate investment horizons and the plan's funding and investment objectives (ii) not take on additional investment risk, relinquish additional returns or otherwise sacrifice the financial interests of participants and beneficiaries for unrelated objectives or goals and (iii) not otherwise subordinate the interests of the participants and beneficiaries for its own or another's interests.
In summary, the Proposal does not completely ban plans from making ESG investments. Yet it is likely to lead many plan fiduciaries to desist from making such investments or at least be sure that such investments are made solely for pecuniary reasons. While the Proposal technically still allows the consideration of collateral ESG benefits when deciding between two economically-indistinguishable investment options, the DOL expresses skepticism whether such an event is likely to occur and the Proposal would require careful documentation of any such conclusion. In the case of an individual account plan, a fiduciary making an ESG-themed investment option available to participants would need to document how it decided that the investment was appropriate based on objective risk-return criteria. For this reason, the DOL warns fiduciaries of individual account plans to carefully read investment disclosures to scrutinize any ESG investment policies and be wary of "ESG rating systems" in particular. Finally, the Proposal outright bans the selection of ESG-investments as a QDIA. The Proposal has a 30-day comment period.
1. 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.
2. 29 C.F.R. 2550.404a-1
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