George Michael Gerstein

George Michael Gerstein advises financial institutions on the fiduciary and prohibited transaction provisions of ERISA. As co-chair of the fiduciary governance group, he assists clients with tracking, and understanding, the numerous fiduciary developments at the federal and state levels, including the rules and regulations of governmental plans. He also advises clients with respect to the fiduciary duty implications of ESG investing.

New DOL Proposal May Be ERISA’s Zero-to-One ESG Moment

Topline & Comment Period Deadline
A new U.S. Department of Labor (DOL) rule proposal would, if adopted, greatly accelerate ERISA fiduciaries’ need to evaluate climate-related financial risk and certain other environmental, social and governance (ESG) considerations during plan investment and proxy voting decision-making. The comment period for the proposal closes on December 13, 2021.1

Who is Affected?
The proposal is directly relevant to all ERISA plan sponsors (both DB and DC), investment managers, and pooled investment funds that hold “plan assets.” Proxy advisory firms and product manufacturers are indirectly affected.

Why the DOL Proposed this Rule
The DOL has long wrestled with ESG, especially when ESG was historically associated with collateral benefits (i.e., non-investment performance reasons). Formalized guidance commenced during the Clinton Administration, with each subsequent administration taking different approaches. It was during the Obama Administration when the DOL first acknowledged that an ESG factor can be material to investment performance.

The Trump Administration reaffirmed the Obama Administration’s stance that an ESG factor can be material to investment performance, but its relevant rulemakings, the Financial Factors rule, and the 2020 proxy voting rule, expressed concern over the putative politicization of ESG investing and skepticism that certain types of ESG investing, particularly screens, was in a plan’s best interest. Many believed the Trump-era rules stigmatized, and, therefore, had a chilling effect on, ESG adoption by ERISA plans.

The DOL under the Biden Administration recognized, and agreed with, the concerns that the Financial Factors and proxy voting rules had a chilling effect on ESG adoption. The DOL, in drafting the proposal, sought to enable ERISA fiduciaries to “better recognize the important role that climate change and other ESG factors can play in the evaluation and management of plan investments, while continuing to uphold fundamental fiduciary obligations.” Also, considering the Administration’s broader policy initiatives to address climate change risk, this new proposal fits into a larger tapestry the White House has weaved as part of its “whole-of-government” approach to climate change and other ESG issues.2

How the Proposal Goes Far Beyond Other DOL Approaches to ESG
As with the Financial Factors rule and Obama-era guidance, the proposal emphatically reaffirms that ESG factors can be material to an investment’s risk-return analysis, and in those situations, a fiduciary should consider them along with any other non-ESG material risks.3 In doing so, the DOL fleshed out various types of ESG risks, and, in considerable detail, the multi-dimensional aspects to an ESG factor. Specifically, the proposal describes the following ESG factors that might be material:

  1. “Climate change-related factors, such as a corporation’s exposure to the real and potential economic effects of climate change including exposure to the physical and transitional risks4 of climate change and the positive or negative effect of Government regulations and policies to mitigate climate change;5
  2. Governance factors, such as those involving board composition, executive compensation, and transparency and accountability in corporate decision-making, as well as a corporation’s avoidance of criminal liability and compliance with labor, employment, environmental, tax, and other applicable laws and regulations; and
  3. Workforce practices, including the corporation’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.”

We think this level of specificity by the DOL reveals an increasingly sophisticated and nuanced understanding of climate change risk. The proposal’s granularity on different ESG risks will likely enhance broader understanding of these risks by fiduciaries, thus aiding adoption.

Beyond that, we think the proposal’s express acknowledgment that government action (whether in policy or in rulemaking) may have a negative or positive material effect on plan investments could be transformational.6 Indeed, there will be winners – and there will be losers – from government policy and rulemakings aimed at a transition to a low-carbon economy (or for some other ESG-related reason), and ERISA fiduciaries would be expected to prepare a plan’s portfolio for these risks and opportunities.

The proposal contemplates a broad scope to government action as a potential material risk or opportunity consideration for ERISA fiduciaries. Consider the following:

  1. The government action appears to include all government levels, both within the United States (federal and state) and abroad;
  2. The government action need not be limited to actual regulation – a government policy, as reflected in the Biden Administration’s A Roadmap to Build a Climate-Resilient Economy, would likely be sufficient for the fiduciary’s consideration, if the policy initiative is likely to have a positive or negative effect on a particular industry, for example; and,
  3. The government action can come from any government agency or body, such as the EPA or the Governor of California, for instance.

A government action that sets things into motion, which would trigger an ERISA fiduciary’s consideration under the proposal, will likely put fiduciaries on high alert and wanting to act quickly in response.

Yet another way in which the proposal could serve as ERISA’s zero-to-one ESG moment is that it appears to create a heavy presumption in favor of ESG adoption. Under the proposed text, a fiduciary must consider the projected return of the portfolio relative to the funding objectives of the plan, “which may often require an evaluation of the economic effects of climate change and other environmental, social, or governance factors on the particular investment….” (emphasis added).7 Though the rule separately lists various ESG factors that may be considered by the fiduciary if material to the risk-return analysis,8 the “which may often require” clause clearly reflects an intention by the DOL that various ESG factors are material, and, therefore, must be considered by a prudent ERISA fiduciary. Further lending credence to the view that the proposal goes beyond simply clarifying that ESG factors may be material, the DOL stated in the preamble, “the proposal makes clear that climate change and other ESG factors are often material and that in many instances fiduciaries [] should consider climate change and other ESG factors in the assessment of investment risks and returns.”9

A fourth reason this proposal is significant is the DOL’s acknowledgment that “all ESG is not equal, and when it is not material to the risk/return analysis, ESG still may be a legitimate collateral benefit for consideration….”10 Using ESG for these types “collateral benefits” is not new; in fact, it has been a means by which fiduciaries have incorporated ESG for decades.11 But the proposal, relative to the Financial Factors rule, streamlines and broadens its usage. For example, the proposal would eliminate the special documentation requirement under the Financial Factors rule related to the use of collateral benefits. Moreover, the proposal expands the types of collateral benefits that may be considered.12

Notably, however, where a collateral benefit ESG factor is used in selecting a designated investment alternative for a participant-directed (e.g., 401(k)) plan lineup, the proposal would require that such reason/benefit “be prominently displayed in disclosure materials provided to participants and beneficiaries.”13 The DOL mentioned that this new disclosure could be added to the existing participant disclosures provided under 29 CFR Section 2550.404a-5.

How QDIAs are Affected
There was considerable controversy over the Financial Factors rule’s prohibition against an ERISA fiduciary selecting a “qualified default investment alternative” (QDIA) in a participant-directed plan lineup, if that fund, product or model portfolio’s investment objectives, goals or principal investment strategies referenced an ESG factor that was selected for collateral benefits. The stakes are high because there is a massive amount of plan assets invested in QDIAs. The proposal eliminates this prohibition. The proposal will likely accelerate the use of ESG funds, products and model portfolios as QDIAs.

How Pooled Investment Vehicles are Affected
The proposal retains the ability of a pooled investment fund that holds “plan assets” to require participating plans to accept the fund’s investment policy statement and/or proxy voting policy, to the extent consistent with ERISA, as a condition to subscribe into the fund. This is helpful insofar as fund managers would otherwise have had to ascertain, and avoid violating, each plan investor’s own investment policy statements and proxy voting policies.

How Brokerage Windows and Self-Directed Brokerage Accounts are Affected
As with the Financial Factors rule, the proposal does not extend to investment funds within brokerage windows and self-directed brokerage accounts. Some plan sponsors have enabled participants to access ESG funds through these arrangements, and that practice may persist.

How Proxy Voting and Other Shareholder Rights are Affected
ESG investing and the exercise of shareholder rights (including, but not limited to, proxy voting) often go together, which is likely why the DOL addressed them here at once. Consistent with the DOL’s longstanding position, the proposal reiterates that proxy voting and the exercise of other shareholder rights on behalf of ERISA plans is fiduciary conduct, and, therefore, is subject to the fiduciary duties set forth in ERISA. The current view of the DOL, as reflected in the proposal, is that exercising shareholder rights is important and should not be discouraged. Yet, the DOL was quick to reaffirm its historical view “that proxies should be voted as part of the process of managing the plan’s investment in company stock unless a responsible plan fiduciary determines voting proxies may not be in the plan’s best interest (e.g., if there are significant costs or efforts associated with voting).”14

The proposal also eliminates the requirement in the 2020 proxy voting rule that there be special monitoring where the authority to exercise shareholder rights on behalf of the plan had been delegated to an investment manager or where a proxy advisory firm provides advisory services. The DOL believes that ERISA’s duties of prudence and loyalty already impose a monitoring obligation, and, therefore, no special monitoring obligation with respect to shareholder rights is warranted.

The 2020 rule provided two safe harbors for fiduciaries to satisfy ERISA’s fiduciary duties in determining whether to vote a proxy. Briefly, the two safe harbors were: (A) a policy to limit voting resources to particular types of proposals that the fiduciary has prudently determined are substantially related to the issuer’s business activities or are expected to have a material effect on the value of the investment, and (B) a policy of refraining from voting on proposals or particular types of proposals when the plan’s holding in a single issuer relative to the plan’s total investment assets is below a quantitative threshold that the fiduciary prudently determines, considering its percentage ownership of the issuer and other relevant factors, is sufficiently small that the matter being voted upon is not expected to have a material effect on the investment performance of the plan’s portfolio (or investment performance of assets under management in the case of an investment manager).

The DOL, in the preamble to the proposal, noted that, because the safe harbors are likely to be widely adopted, it is vital that they actually safeguard the interests of the plans. The DOL is currently not confident the two safe harbors from the 2020 rule are “necessary or helpful,” and, therefore, did not include them in the proposal. As noted below, however, the DOL solicits comments on whether the safe harbors should be retained.

The proposal eliminates a requirement from the 2020 rule that mandated fiduciaries to maintain records on proxy voting activities and the exercise of other shareholder rights.

The proposal retains a requirement that the fiduciary exercise prudence and diligence in the selection and monitoring of persons hired to provide research and analysis, recommendations regarding proxy votes, proxy voting administrative services, recordkeeping and other services related to shareholder rights. This is why the proposal indirectly affects proxy advisory firms.

Some Questions to Consider
The comment period closes on December 13, 2021. The DOL is interested in feedback and has solicited comments on the proposal, including:

  1. Should a final rulemaking retain the specific examples of ESG risks that may be material (e.g., climate change, etc.)?
  2. Is the proposal’s revised language around the tie-breaker test clear and appropriate? Should a final rule provide greater specificity on which collateral benefits may be considered?
  3. Should a final rule retain the enhanced documentation requirement when a plan investment option is selected for collateral benefits?
  4. Should the safe harbors in the 2020 proxy voting rule be retained?
  5. Would the proposal cause plans to modify their holdings, such as in favor of mutual funds and away from individual companies, so as to avoid the proxy voting requirements set forth in the proposal?
  6. Would the proposal affect how a fiduciary would manage the plan’s mutual fund shares in terms of exercising shareholder rights appurtenant to the mutual fund shares?
  7. Are the proposal’s requirements regarding the selection and monitoring of proxy advisory firms and other service providers regarding the exercise of shareholder rights necessary and could they be read as creating special duties and requirements beyond those already existing under ERISA?
  8. Should the DOL retain the specific requirement that a fiduciary may not adopt a practice of following the recommendations of a proxy advisory firm without a determination that such firm’s proxy voting guidelines are consistent with the fiduciary’s duties under ERISA? Do the proposal’s other provisions otherwise address concerns related to fiduciaries’ use of automatic voting mechanisms?

Final Thoughts
We believe there is more to this proposal than what may initially meet the eye. The DOL is clearly trying to nudge ERISA fiduciaries into considering ESG factors in their investment and proxy voting decision-making. Should the proposal be adopted as-is, it will likely serve as an accelerant to ESG adoption by ERISA plans and plan asset vehicles. Because these consequences would be profound, plan sponsors and other fiduciaries should carefully consider whether to provide feedback and comments to the DOL in response to the proposal.

____________________

1 The proposed rule would amend the “Investment Duties” regulation set forth at 29 C.F.R. Section 2550.404a-1.

2 See, e.g., A Roadmap to Build a Climate-Resilient Economy, https://www.whitehouse.gov/wp-content/uploads/2021/10/Climate-Finance-Report.pdf, Executive Order 13990, “Protecting Public Health and the Environment and Restoring Science to Tackle the Climate Crisis,” 86 Fed. Reg. 7037 (Jan. 25, 2021), and Executive Order 14030, “Executive Order on Climate-Related Financial Risk,” 86 Fed. Reg. 27967 (May 25, 2021).

3 Since 2015, the DOL has repeatedly asserted that ESG can be a material risk factor, and, in those situations, should be considered by an ERISA fiduciary as part of a prudent process. This holds true under the Obama, Trump and Biden Administrations. That the DOL, under both Democrats and Republicans, has acknowledged that ESG risks can be material to investment performance, strongly suggest this issue is officially off the table.

4 The preamble to the proposal notes, “[t]ransition risk reflects the risks that carbon-dependent businesses lose profitability and market share as government policies and new technology drive the transition to a carbon-neutral economy.”

5 Per the DOL, the “imminent or proposed regulations…to reduce greenhouse gas emissions in the power sector, and other policies incentivizing a shift from carbon-intensive investments to low-carbon investments, [which] could significantly lower the value of carbon-intensive investments while raising the value of other investments.”

6 See George Michael Gerstein, Climate Change Defines the Fiduciary, Bloomberg Law, Oct. 2, 2017 (“The first major component of climate risk relates to forthcoming changes in policy and law at the international, national and local level.”); see also Mercer, Investing in a Time of Climate Change, 2015, https://www.mercer.com/content/dam/mercer/attachments/global/investments/mercer-climate-change-report-2015.pdf.

7 Proposed 29 C.F.R. Section 2550.404a-1(b)(2)(ii)(C).

8 Proposed 29 C.F.R. Section 2550.404a-1(b)(4).

9 86 Fed. Reg. 57272, 57276 (Oct. 14, 2021).
10 Id. at 57279.

11 The analytic framework for using collateral benefits has been called the “tie-breaker” test.

12 Cf. 86 Fed. Reg. at 57280 (referencing “corporate ethos” and “esprit de corps of the workforce” as collateral benefits) with 85 Fed. Reg. 72846, 72862 (“responding to participant demand in order to increase retirement plan savings or investments in contribution creating jobs for current or future plan participants may be consistent with the interests of participants and beneficiaries in their retirement income or financial benefits under the plan, while selecting based on which investment would bring greater personal accolades to the chief executive officer of the sponsoring employer, or solely on the basis of a fiduciary’s personal policy preferences, would not.”).

13 The DOL noted in the preamble that, “[t]he essential purpose of this proposed disclosure requirement is to ensure that plan participants are given sufficient information to be aware of the collateral factor or factors that tipped the scale in favor of adding the investment option to the plan menu, as opposed to its economically equivalent peers that were not.”

14 See also 86 Fed. Reg. at 57281 (“Prudent 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 interest.”).

Information contained in this publication should not be construed as legal advice or opinion or as a substitute for the advice of counsel. The articles by these authors may have first appeared in other publications. The content provided is for educational and informational purposes for the use of clients and others who may be interested in the subject matter. We recommend that readers seek specific advice from counsel about particular matters of interest.

Copyright © 2021 Stradley Ronon Stevens & Young, LLP. All rights reserved.

Greetings from Texas USA. Retro postcard with patriotic stars and stripes

Texas and Maine Approaches to Fossil Fuel Divestment a Cautionary Tale for Investment Managers

State and local governmental plans, which are excluded from ERISA, are subject to idiosyncratic legal requirements, including specific investment restrictions. These plans are also not immune to the political winds blowing in that state. Nowhere is this more apparent than recent developments out of the States of Texas and Maine with respect to fossil fuel divestment. Investment managers of any governmental plan, especially those that take environmental, social and governance (ESG) factors into account, should pay close attention to these developments. Private equity and other fund managers, for the reasons stated below, should also take note.

Texas
On June 14, 2021, Texas Governor Greg Abbott signed into law SB 13. This new law, which goes into effect on September 1, 2021, generally prohibits state governmental entities, including the Employees Retirement System of Texas and the Teacher Retirement System of Texas, from directly or indirectly holding the securities of a publicly-traded financial services, banking or investment company that “boycotts” companies that (i) explore, produce, utilize, transport, sell or manufacture fossil fuel-based energy and (ii) do not “commit or pledge to meet environmental standards beyond applicable federal and state law….” The concept of “boycott” is not limited to divestment; rather, it picks up activity that is designed to inflict economic harm on the energy company. The exercise of certain shareholder rights could possibly amount to a “boycott” of a company.

The law also generally prohibits governmental entities from contracting with a service provider unless the contract provides a written verification from the service provider that it does not boycott energy companies and will not boycott energy companies during the term of the contract. This applies to contracts entered into on or after September 1, 2021.

Fiduciaries of these Texas governmental plans remain subject to countervailing fiduciary duties under Texas law, including the Texas Constitution. The new law crucially allows for breathing space between these core fiduciary duties and the state’s interest in protecting significant portions of its economy.

The law provides that these governmental entities are not required to divest from any holdings in “actively or passively managed investment funds or private equity funds.” However, the governmental entities are required to submit letters to the managers of these funds requesting that they remove from the portfolio financial companies that the state comptroller has designated as boycotting energy companies. The Texas governmental entities will alternatively request that the managers “create a similar actively or passively managed fund with indirect holdings devoid of listed financial companies.” Investment managers should be on the lookout for these letters starting this coming Fall.

Maine
Meanwhile, in Maine, the House of Representatives recently passed a bill that calls for the divestment of fossil fuel companies by the Maine Public Employees Retirement System (Maine PERS) and other permanent state funds by 2026. As with Texas, the law is sensitive to the overriding fiduciary duties that apply to the management of these assets. An official for Maine PERS recently testified that, “[p]ermanently striking broad portions of the financial market is incompatible with earning optimal returns for member retirements, will not change corporate behavior, and may not advance the social goals sought because investments are rarely one dimensional.”

Takeaways
Governmental plans invested in separate accounts or commingled funds managed by an investment manager have always posed risks to that manager, as these plans are subject to their own fiduciary duties and investment restrictions. Though the state laws applicable to governmental plans may contain ERISA-like language, we caution investment managers from relying on ERISA or DOL guidance as a failsafe way to manage governmental plan assets. As evidenced from the disparate approaches the States of Texas and Maine have taken, investment managers should pay close attention to the specific rules applicable to these plans to avoid running afoul of state law. With the calls for fossil fuel divestment growing louder in some quarters, and as other ESG issues come to the fore, careful due diligence on the part of investment managers is essential.

Please contact George Michael Gerstein to discuss these matters or other due diligence issues related to governmental plans.

Significant ESG Movement on the ERISA Front

Legislation is afoot that would amend ERISA to expressly permit fiduciaries to account for environmental, social and governance (ESG) factors as part of their fiduciary duties. The proposed legislation, the Financial Factors in Selecting Retirement Plan Investments Act, was introduced by Senator Tina Smith (D-MN). It expressly permits, but does not compel, fiduciaries to “consider” ESG and similar factors when selecting investments or strategies on behalf of an ERISA-covered retirement plan. The legislation also permits fiduciaries to consider “collateral” factors “as tie-breakers when competing investments can reasonably be expected to serve the plan’s economic interest equally well with respect to expected return and risk over the appropriate time horizon.” Under either scenario, the fiduciary need not “maintain any greater documentation, substantiation, or other justification” when considering the ESG or similar factors. Notably, the bill provides that an investment selected based on ESG or similar factors (including such factors used as a tie-breaker) may be a permissible default investment option (a “qualified default investment alternative” (QDIA)) for a plan that uses a default investment option as part of its menu. Lastly, the US Department of Labor’s (DOL) 2020 Financial Factors rule would cease to have force or effect upon the enactment of the legislation.

Meanwhile, President Joe Biden just issued an Executive Order on Climate-Related Financial Risk, in which he directed the (DOL to consider proposing by September 2021 a rule that would suspend, revise or rescind the Financial Factors and proxy voting rules promulgated under the Trump Administration. The Executive Order further directed the DOL to consider taking any other action under ERISA “to protect the life savings and pensions of Unites States workers and families from the threats of climate-related financial risk.”

Should the legislation pass, it could provide fiduciaries limited additional comfort that the incorporation of ESG factors in their investment decision-making complies with ERISA’s fiduciary duties. The trend is toward incorporating ESG factors into an investment process for their effect on investment performance, and existing guidance, including the Financial Factors rule, should already provide fiduciaries enough of a roadmap to do so in accordance with ERISA. The legislation also seeks to dial back the documentation requirements of the Financial Factors rule, which may indeed ease some of the angst over foot faults and the resulting liability exposure. Though the DOL removed all references to “ESG” in the final Financial Factors rule, some argued the rule’s aggressive proposal, coupled with the Trump Administration’s overall stance on climate change, was designed to curb ERISA fiduciaries’ appetite for ESG. Yet, carefully documenting important decisions is already a well-established requirement and technique used by fiduciaries to mitigate their fiduciary duty risk.

It is a big deal that, with a rescission of the Financial Factors rule, fiduciaries would seemingly no longer have to comb through a fund’s prospectus and marketing materials for references to non-pecuniary factors, nor would the fiduciary need to scrutinize a fund manager’s use of screens or ratings. These requirements obviously present legal risk to a fiduciary and, therefore, may deter some fiduciaries from considering ESG products. But they also may serve as useful guideposts for fiduciaries trying to avoid selecting a greenwashed fund. An unintended consequence of the legislation could be that stripping out specific actions a fiduciary must take to navigate the intricate ESG landscape perhaps deters more plan sponsors from adding ESG to their plans than if the guideposts (and associated legal risks) remained.

It is also a big deal that the proposed legislation would allow a fund, which incorporates ESG factors for non-investment performance reasons, to serve as QDIA. The Financial Factors rule outright prohibited such a result. This change will likely give some plan sponsors comfort in selecting an ESG-themed QDIA that does not base ESG decisions on risk and return criteria, for example. However, the zealous litigation routinely brought against defined contribution plan sponsors over the selection of investment options has largely resulted in playing it safe. Plan sponsors know they will be second-guessed. This change, therefore, is unlikely to dramatically increase the adoption of ESG by ERISA plans, which continue to lag other institutional investors on that score.

The Executive Order is worth watching. The DOL may opt to impose affirmative obligations on fiduciaries to mitigate climate change risk to the plan. The imposition of any such obligation will likely be litigated.

In sum, ESG is and will remain entirely relevant to ERISA fiduciaries. Under ERISA and existing guidance, fiduciaries may take ESG factors into account when investing plan assets or selecting investment options for a plan lineup. With ESG top of mind for the current Congress and White House, ERISA fiduciaries should continue to evaluate whether taking ESG into account is prudent under the circumstances.