The U.S. Department of Labor (DOL) has finalized a rulemaking that pertains to proxy voting and the exercise of other shareholder rights with respect to employee benefit plans subject to the U.S. Employee Retirement Income Security Act of 1974, as amended (ERISA).1 The rule applies to plans directly, as well as to commingled investment funds that hold “plan assets.”2 Plan sponsors, investment advisers registered with the U.S. Securities and Exchange Commission (SEC), and other service providers that either exercise shareholder rights on behalf of plans or who appoint those who do should pay particular attention to this final rule.3
As with the DOL’s recent Financial Factors rulemaking, this rule’s genesis was probably the DOL’s concern over the striking growth of environmental, social & governance (ESG) investing. Engagement with a company’s board, for example, is a popular method used by managers to address ESG concerns. But both rules apply much more broadly, including to those managers and mandates that do not take ESG factors into account. Neither this rule nor the Financial Factors rule, is limited to ESG.
The exercise of shareholder rights, including proxy voting, has long been considered fiduciary conduct under ERISA. This rule retains that characterization and defines the scope of responsibilities. In doing so, the rule supersedes DOL Interpretive Bulletin 2016-01 and the relevant portions in DOL Field Assistance Bulletin 2018-01.
As discussed more fully below, fiduciaries of plans and plan asset vehicles will need to review their proxy voting policies and practices regarding their use of proxy advisors, especially when those advisors offer voting recommendations or their platforms pre-populate votes.4 With this rule, proxy advisory firms continue to face increased scrutiny from U.S. regulators, notably the SEC and DOL, over their practices and influence.
From a substantive standpoint, the rule compels fiduciaries to only exercise shareholder rights, including proxy voting, if they are undertaken solely in accordance with the economic interests of the plan and its participants and beneficiaries. This entails the fiduciary discerning some economic benefit to the plan, beyond the plan merely being a shareholder, resulting from the exercise of shareholder activities by the plan alone or together with other shareholders.5 Fiduciaries may consider the longer-term consequences and potential economic impacts from the exercise of such rights, even if they are not currently readily quantifiable, which should strengthen (or at least not hinder) proxy voting and engagement related to material ESG issues.6 Importantly, a discernible economic benefit to the plan must be initially identified to pass muster under the rule, even if the shareholder activity does not result in a direct or indirect cost to the plan.
In the DOL’s view, for example, a fiduciary may have to vote against a shareholder proposal that would result in the issuer incurring direct or indirect costs if such proposal did not also describe “a demonstrable expected economic return” to the issuer. On the other hand, “the costs incurred by a corporation to delay a shareholder meeting due to lack of a quorum is an example of a factor that can be appropriately considered as affecting the economic interest of the plan.”
The costs of proxy voting and other shareholder rights must also be considered, as they too affect the economic interest of the plan. These costs may include direct costs to the plan, such as expenditures for analyzing portfolio companies and the matters to be voted on, determining how the votes should be cast, and ultimately submitting proxy votes to be counted. Moreover, the DOL notes that “[i]f a plan can reduce the management or advisory fees it pays by reducing the number of proxies it votes on matters that have no economic consequence for the plan that also is a relevant cost consideration.”7 Indirect costs are also relevant. For example, the fiduciary should consider the opportunity costs of the exercise of shareholder rights, such as opportunity costs for the client resulting from restricting the use of securities for lending to preserve the right to vote.8
The rest of the rule is more process-oriented, which speaks to how fiduciaries can satisfy these substantive obligations in practice.
First, fiduciaries need to evaluate material facts that form the basis for any particular proxy vote or other exercise of shareholder rights. Here, fiduciaries should consider material information that is known by, available to, or reasonably should be known by the fiduciary. In this respect, the DOL pointed to the fact that, under recent SEC guidance, clients of proxy advisory firms may become aware of additional information from an issuer that is the subject of a voting recommendation, and that an ERISA fiduciary would be expected to consider the relevance of such additional information if material.
Second, fiduciaries must maintain records on proxy voting activities and other exercises of shareholder rights. For fiduciaries that are SEC-registered investment advisers, the DOL intends that these recordkeeping obligations would be applied in a manner that aligns to similar proxy voting recordkeeping obligations under the U.S. Investment Advisers Act of 1940, as amended (Advisers Act).
Third, and as applicable, fiduciaries must exercise prudence and diligence in the selection and monitoring of (i) investment managers charged with proxy voting and (ii) proxy advisory firms selected to advise or otherwise assist with exercises of shareholder rights, such as providing research and analysis, recommendations regarding proxy votes, administrative services with voting proxies, and recordkeeping and reporting services. The fiduciary should consider the qualifications of the service provider, the quality of services being offered, and the reasonableness of fees charged in light of the services provided. ERISA fiduciaries should also ensure that, when considering proxy recommendations, they are fully informed of the potential conflicts of interest of proxy advisory firms and the steps such firms have taken to address them (e.g., reviewing proxy advisor conflict of interest disclosures, etc.). Finally, fiduciaries should review the proxy voting policies and/or proxy voting guidelines and the implementing activities of the service provider; this requirement, however, does not require use of custom policies.
Fiduciaries may adopt proxy voting policies pursuant to a safe harbor and, if so, review them periodically for compliance with the rule (e.g., every two years). These policies may not preclude (i) submitting a proxy vote when the fiduciary prudently determines that the matter being voted upon is expected to have a material effect on the value of the investment or the investment performance of the plan’s portfolio (or investment performance of assets under management in the case of an investment manager) after taking into account the costs involved, or, conversely, (ii) refraining from voting when the fiduciary prudently determines that the matter being voted upon is not expected to have such a material effect after taking into account the costs involved. The rule specifically provides two safe harbors, either or both of which may be utilized when deciding whether to vote. The safe harbors are not the exclusive means to satisfy the rule or represent minimum requirements.
- Safe Harbor #1: 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. The reference to the value of the investment rather than the plan’s total investment is intended to make clear that the evaluation could be at the investment manager level dealing with a pool of investor’s assets or at the aggregate plan level. The DOL expects that proposals relating to corporate events (e.g., mergers and acquisitions, dissolutions, conversions, or consolidations), buybacks, issuances of additional securities with dilutive effects on shareholders, or contested elections for directors, are the types of votes that would materially affect the investment.
- Safe Harbor #2: 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).
In response to concerns raised by some commenters, the safe harbors in the final rule are intended to be flexible enough to clearly enable fiduciaries to vote to establish a quorum of mutual fund shareholders or on other fund matters. On this point, the DOL noted that fiduciaries may also adopt voting policies that consider the detrimental effect on the plan’s investment due to the costs (direct and indirect) incurred related to delaying a shareholders’ meeting. The rule envisions fiduciaries having considerable flexibility in fashioning proxy voting policies and the opportunity to deviate from the policies in certain instances.
Proxy advisors remain top-of-mind for the DOL. The safe harbors are intended to provide fiduciaries the ability to operationalize the rule without having to seek recommendations on a vote-by-vote basis from proxy advisors. The rule prohibits fiduciaries from adopting a practice of following the recommendations of a proxy advisory firm without first determining that such firm or service provider’s proxy voting guidelines are consistent with the fiduciary’s obligations under the rule.9 As with the SEC, the DOL expects fiduciaries, under certain circumstances, to conduct a more particularized voting analysis than what may be conducted under the general guidelines. The DOL acknowledged that some plans rely on proxy advisory firms’ pre-population and automatic submission mechanisms for proxy votes but noted that adopting such a practice for all proxy votes effectively outsources their fiduciary decision-making authority.
The rule continues to recognize and account for the fact that an investment manager of a plan asset pooled investment vehicle may be subject to an investment policy statement that conflicts with the policy of another plan investor. In this case, compliance with ERISA requires the investment manager to reconcile, to the extent possible, the conflicting policies (assuming compliance with each policy would otherwise be consistent with ERISA). In the case of proxy voting, the investment manager generally must vote (or abstain from voting) the relevant proxies to reflect such policies in proportion to each plan’s economic interest in the investment vehicle. Investment managers of pooled funds, however, typically develop an investment policy statement and require participating plans to accept the investment manager’s proxy voting policy as a condition to subscribe, which remains permitted under the rule. The investment manager’s policies would need to comply with this rule, and the fiduciary responsible for the plan’s subscription in the fund would be obligated to assess whether the investment manager’s policies are consistent with this rule before subscribing in the fund.10
As noted above, the rule does not directly apply to investment vehicles that do not hold plan assets, such as mutual funds. The rule, for example, does not require ERISA fiduciaries to scrutinize a mutual fund’s voting practices in which the plan has an investment. The DOL does, however, contemplate that ERISA fiduciaries will consider the mutual fund’s voting policies as part of its overall consideration of the mutual fund as a prudent investment in accordance with the Financial Factors rule. Thus, fiduciaries should consider whether the investment fund’s voting policies are expected to have a material effect on the risk and/or return of an investment.
The rule’s compliance date is Jan. 15, 2021, subject to the following:
- All fiduciaries should begin to review their proxy voting policies and practices in light of the new rule, especially plan investment committees and investment managers of separate accounts.
- Fiduciaries that are investment advisers registered with the SEC must comply by Jan.15, 2021, with respect to the requirements to (i) evaluate material facts that form the basis for any particular proxy vote or other exercise of shareholder right and (ii) maintain records on proxy voting activities and other exercises of shareholder rights. The DOL intends that these requirements align with existing obligations under the Advisers Act, including Rules 204-2 and 206(4)-6 thereunder and the 2019 SEC Guidance and 2020 SEC Supplemental Guidance. Other types of fiduciaries have until Jan. 31, 2022, to comply with these requirements.
- All fiduciaries shall have until Jan. 31, 2022, to comply with the requirements that they not adopt a practice of following the recommendations of a proxy advisory firm or other service provider without a determination that such firm or service provider’s proxy voting guidelines are consistent with the rule. Fiduciaries of pooled investment vehicles also have until that date to confirm the fund’s proxy voting policies with the rule.
1 The rule does not apply to the exercise of shareholder rights on behalf of non-ERISA plans, such as IRAs and governmental plans.
2 Investment companies registered under the U.S. Investment Company Act of 1940, as amended, do not hold plan assets and thus not subject to ERISA or this rule. Hedge funds and other commingled vehicles that fail to satisfy one of the exceptions set forth in the DOL’s plan assets regulation, on the other hand, are subject to ERISA and this rule. Similarly, bank-maintained collective investment trusts are subject to ERISA and this rule.
3 The rule does not apply to proxy voting that is passed through to participants and beneficiaries with accounts holding such securities in an individual account plan.
4 Firms that agree to act as “investment managers,” within the meaning of Section 3(38) of ERISA, should ensure the investment management agreement is clear on who has the responsibility to exercise shareholder rights on behalf of the plan. When the authority to manage plan assets has been delegated to an investment manager, the investment manager has exclusive authority to vote proxies or exercise other shareholder rights, except to the extent the plan, trust document, or investment management agreement expressly provides that the responsible named fiduciary has reserved to itself (or to another named fiduciary so authorized by the plan document) the right to direct a plan trustee regarding the exercise or management of some or all of such shareholder rights.
5 The proposed rule included a requirement that the fiduciary consider only factors that they prudently determine will affect the economic value of the plan’s investment based on a determination of risk and return over an appropriate investment horizon consistent with the plan’s investment objectives and the funding policy of the plan. The DOL eliminated this condition because of its potential compliance costs and that it may not be apparent that a particular vote will affect the plan’s investment return. A similar revision was made to the final Financial Factors rulemaking; thus, even the DOL admits fiduciaries need not be clairvoyant in evaluating how an investment decision, or the exercise of shareholder rights, on some basis (ESG or not) will materially affect the plan’s return in the future. Instead, fiduciaries should follow a thoughtful, prudent process in reaching the position that an investment, or the exercise of rights appurtenant to such investment, is in the economic interests of the plan.
6 As with the Financial Factors rulemaking, the DOL cautioned fiduciaries against taking too elastic an interpretation of economic benefits that could flow to the plan, by noting that “vague or speculative notions that proxy voting may promote a theoretical benefit to the global economy that might redound, outside the plan, to the benefit of plan participants would not be considered an economic interest under the final rule.”
7 The DOL also noted that it would “not be appropriate for plan fiduciaries, including appointed investment managers, to incur expenses to engage in direct negotiations with the board or management of publicly held companies with respect to which the plan is just one of many investors.” It is questionable whether this assertion is supported by the rule itself.
8 The DOL acknowledged that multiple investment managers may be responsible for managing a plan’s assets, and accordingly revised the rule to permit each investment manager to apply the rule to its specific mandate. The DOL noted, however, that “where the plan’s overall aggregate exposure to a single issuer is known, the relative size of an investment within a plan’s overall portfolio and the plan’s percentage ownership of the issuer, may still be relevant considerations in appropriate cases in deciding whether to vote or exercise other shareholder rights.”
9 The fiduciary selecting and using a proxy advisor, therefore, must review the proxy advisor’s voting guidelines against this rule in addition to separately determining whether a specific recommendation necessitates a particularized analysis. The review of the proxy advisor proxy voting guidelines should be addressed at the outset of the relationship with the proxy advisor and when the proxy advisor updates its guidelines (e.g., annually).
10 Uniform policies utilized by the investment manager across client accounts are still permissible under the rule, provided the policies comply with this rule.
The U.S. Department of Labor (DOL) finalized amendments to the investment duties of a fiduciary subject to the U.S. Employee Retirement Income Security Act of 1974, as amended (ERISA).1 The rule amendments were aimed at ERISA fiduciaries that utilize products and strategies that incorporate environmental, social and/or governance (ESG) factors. Though the DOL opted not to let the final rule get bogged down in the ESG-lexicon quagmire by removing all express references to ‘ESG,’ the final rule clearly and directly applies to fiduciaries that consider ESG factors when investing on behalf of ERISA plans and funds that hold “plan assets.” Indeed, all ERISA fiduciaries that make investment decisions (including the selection of investment funds for participant-directed plan lineups), regardless of whether ESG is even implicated, should review this rule carefully.
The rule becomes effective 60 days after publication in the Federal Register. Plans have until April 30, 2022 to make any changes to their “qualified default investment alternatives” (QDIAs), within the meaning of 29 C.F.R. § 2250.404c-5, as a result of this rule. The rule contemplates a grandfathering mechanism, which will be highly fact-specific.2 The DOL further noted that it “will not pursue enforcement, and does not believe any private action would be viable, pertaining to any action taken or decision made with respect to an investment or investment course of action by a plan fiduciary prior to the effective date of the final rule to the extent that any such enforcement action would necessarily rely on citation to this final rule.”
The final rule builds upon the original investment duties regulation, which provided a safe harbor for fiduciaries in satisfying their duty of prudence under ERISA. The final rule, like the original, compels fiduciaries to give appropriate consideration to numerous factors regarding the composition of the plan portfolio as it relates to diversification, liquidity and current return of the portfolio relative to the anticipated cash flow needs of the plan, and the projected return of the portfolio relative to the funding objectives of the plan. Importantly for 3(38) investment managers, the final rule preserves the aspects of the original regulation that allowed investment managers to rely and act on information provided by the appointing fiduciary in fulfilling these duties with respect to the plan portfolio over which it has discretion.
This final rule does not address an ERISA fiduciary’s responsibilities with respect to proxy voting and the exercise of other shareholder rights. The DOL recently proposed a rule on this topic, though it has yet to move forward with the proposal. Until a final rule emerges, fiduciaries should continue to follow DOL Interpretive Bulletin 2016-01 and DOL Field Assistance Bulletin 2018-01.
The final rule preserves the essence of the original investment duties regulation (and ERISA) by allowing ERISA fiduciaries considerable leeway in crafting investment portfolios. The DOL thus admitted that, as a general matter, there is total parity between investment strategies and products, whether ESG-related or not. In other words, an ERISA fiduciary may manage plan assets while taking into account ESG risks and opportunities without violating the rule.
The final rule presents five distinct issues worth considering (1) pecuniary factors; (2) comparing investment alternatives; (3) duty of loyalty; (4) special circumstances/non-pecuniary factors/tie-breakers, and (5) QDIAs.
Whether investing on behalf of an ERISA-covered defined benefit plan or selecting plan investment options for a participant-directed plan, the final rule compels fiduciaries to consider pecuniary factors only, absent special circumstances (discussed below), when evaluating the risk and return profiles of investments. The rule defines a “pecuniary factor” as one “that a fiduciary prudently determines is expected to have a material effect on the risk and/or return of an investment based on appropriate investment horizons consistent with the plan’s investment objectives and the funding policy….”3 The DOL expressly recognized that ESG factors may be pecuniary factors under the rule.4 The requirement that only pecuniary factors be considered is a legal requirement, not a safe harbor.
The final rule’s definition of pecuniary factors is forward-looking in nature, meaning a fiduciary need not know that a factor will materially affect risk/return at the time of the investment. Instead, the fiduciary must be prudent in coming to that conclusion based on the facts and circumstances. This change by the DOL should give comfort to fiduciaries who are closely tracking the emerging data of various ESG (and other) factors’ impact on investment performance. Fiduciaries should take note that the DOL has repeatedly cautioned fiduciaries against disproportionately weighting the materiality of a factor based on existing data.
The DOL opted to avoid defining the slippery concept of materiality. The DOL said in the preamble to the final rule that it “believes that fiduciaries and investment managers are generally familiar with that concept from its use in connection with both ERISA and the federal securities laws.” This seemingly allows the concept of pecuniary factors to evolve with market consensus on materiality and ultimately on how other regulators define materiality for these purposes. Yet, the DOL acknowledged that the following may be material, and thus, pecuniary factors under the rule: (1) an investment manager’s brand/reputation; (2) proprietary products; and (3) a fund or product’s legal regime that confers greater investor protection and/or improved disclosures.
As with any other evaluation of prospective investments, a fiduciary should first determine that it has sufficient skills and expertise to determine that the ESG (or any other) factor presents economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories (if not, the determination should be made by another fiduciary that has such expertise and skill).5 Moreover, the DOL apparently will look for risk controls in place commensurate with the complexity, nature and size of the investment activity (the implication is that fiduciaries that consider ESG factors should have rigorous controls in place to ensure that they are properly determining factors to be pecuniary factors under the rule).
In the context of ERISA-covered participant-directed plans, the decision as to which funds populate the plan lineup is subject to ERISA’s fiduciary duties and this new rule, among others. In the preamble to the final rule, the DOL addressed whether a fiduciary could select an ESG investment fund, product or model portfolio based solely on participant request or because of the potential for increased contributions to the plan. In short, these types of considerations are not pecuniary factors and, therefore, the responsible fiduciary may not base its decision to include an ESG fund, product or model portfolio as a designated investment alternative without separately determining that the pecuniary reasons for such inclusion satisfy the rule. As discussed below, however, participant requests and the like may be “tie-breakers” in selecting between alternative investment options.
Comparing Investment Alternatives
Under the final rule, the fiduciary must compare investments or investment courses of action (e.g., selection of designated investment alternative for participant-directed plans) based on factors “that are expected to result in a material difference among reasonably available alternatives with respect to risk and/or return.” This comparison requirement is, therefore, not limitless. Thus, a fiduciary does not need to consider all factors that differentiate investment funds, only ones that are pecuniary. Moreover, fiduciaries are under no obligation to scour the market for the lowest cost investment opportunities, much less select the cheapest available investments.
The DOL further confirmed that the fiduciary need not expend considerable resources on searching for investment opportunities or considering an infinite number of investment alternatives. Instead, the fiduciary’s duty to evaluate alternative investment opportunities is limited to comparing alternatives that are reasonably available under the circumstances. This means that the rule “allow[s] for the possibility that the characteristics and purposes served by a given investment…may be sufficiently rare that a fiduciary could prudently determine, and document, that there were no other reasonably available alternatives for purposes of this comparison requirement.”
Duty of Loyalty
Fiduciaries are already well aware that ERISA imposes a duty of loyalty, in addition to the prudence requirements discussed above. The final rule incorporates this specific fiduciary duty by prohibiting fiduciaries from subordinating the interests of plan participants and beneficiaries in their retirement income to non-pecuniary goals. Though this may seem to be an example of form over function, the DOL opted not to include the duty of loyalty under the rule’s general safe harbor characterization, meaning fiduciaries will likely not only be conservative in satisfying the rule’s requirements but may also opt for even stronger controls/analysis/documentation than the rule technically requires to ensure they do not run afoul of the loyalty concerns the DOL has expressed in the context of ESG.
Special Circumstances/Non-Pecuniary Factors/Tie-Breakers
Prior DOL guidance provided that if, after an evaluation, alternative investments appear economically indistinguishable, a fiduciary may then, in effect, “break the tie” by relying on a non-pecuniary factor. Commenters argued that the proposal effectively required equivalence between investments. The DOL suggested that they did not mean for investment alternatives to have identical characteristics, just equivalent roles in the plan’s investment portfolio. Commenters argued that indistinguishability in liquid markets is all but impossible and are, in turn, never perfectly correlated.
Under the final rule, if a fiduciary is unable to determine which investment is in the best interests of the plan on the basis of pecuniary factors alone, the fiduciary may base the investment decision on non-pecuniary factors, provided the fiduciary documents the following: (1) why pecuniary factors were not sufficient to select the investment; (2) how the investment compares to the alternative investments; and (3) how the chosen non-pecuniary factors are consistent with the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan. This effectively prohibits ERISA fiduciaries from choosing investments with expected reduced returns or enhanced risks in order to secure non-pecuniary benefits.
The third condition is a hemmed-in version of the historical tie-breaker test. Simply, the DOL split the difference from the proposal, which all but eliminated the tie-breaker mechanism, and instead has allowed a tie-breaker but only on the basis of a pecuniary-light factor. Under the final rule, a fiduciary no longer appears able to select an investment fund based on the ethos of the plan sponsor (assuming the other conditions of the rule are met). Instead, the non-pecuniary factor must at least have some nexus to participants’ and beneficiaries’ retirement income or financial benefits. The DOL indicated that responding to participant demand in order to increase retirement plan savings may be consistent with the interests of the participants and interests in their retirement income or financial benefits under the plan. In contrast, selecting an investment option that “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.”
The same standards apply to selecting investment funds, products and model portfolios for a participant-directed plan lineup. The DOL admonished fiduciaries to “carefully review the prospectus or other investment disclosures for statements regarding ESG investment policies and investment approaches.” In particular, the DOL stressed that fiduciaries should be “cautious in exercising their diligence obligations under ERISA when disclosures, whether in prospectuses or marketing materials, contain references to non-pecuniary factors or collateral benefits in a fund’s investment objectives or goals or its principal investment strategies.”
The DOL envisions that fiduciaries will evaluate fund prospectuses and other disclosures to determine if the fund uses an ESG or sustainability rating system of index. If the fund uses such a rating system or index, the fiduciary, as part of its due diligence, would need to consider whether the rating system or index “evaluates one or more factors that are not financially material to investments.” If so, the selection of the fund is a special circumstance, thereby requiring the fiduciary to satisfy the aforementioned heightened requirements.
On this point, the DOL indicated that a fiduciary would have to understand how the ratings are actually determined, such as the rating’s methodology, weighting, data sources, performance benchmarks and the underlying assumptions utilized. Moreover, “a fiduciary may not assume that combining [multiple factors] into a single rating, index or score creates an amalgamated factor that is itself pecuniary.”
On QDIAs, DOL stressed that the proposal was never intended to block investment funds, products or model portfolios that treat ESG factors as pecuniary in nature from being QDIAs. The final rule better captures this intent by only prohibiting those QDIAs whose investment objectives, goals or principal investment strategies include, consider or indicate, one or more non-pecuniary factors. Crucially, the tie-breaker mechanism is not available when selecting QDIAs. This means that a fund will no longer qualify as a QDIA if its investment objectives, goals or principal strategies include a non-pecuniary factor, even if including such fund as a QDIA is in response to participants’ request or otherwise increase the desirability of the plan to participants.
The DOL claimed fiduciaries can apply the rule to QDIAs easily and objectively. They indicated, for example, that a plan fiduciary can simply look at the investment fund’s prospectus to determine whether the fund is qualified or disqualified as a QDIA under the final rule. The DOL specifically pointed to Form N-1A to ascertain whether non-pecuniary considerations form a material part of a fund’s investment objectives or principal strategies. The DOL is under the impression that disclosures for other types of investment vehicles, such as collective investment trusts and insurance separate accounts, would provide sufficient information for these purposes.
As noted above, the DOL envisions fiduciaries evaluating fund prospectuses and other disclosures to determine if the fund uses an ESG or sustainability rating system of index. Again, if the fund uses such a rating system or index, the fiduciary, as part of its due diligence, would need to consider whether the rating system or index “evaluates one or more factors that are not financially material to investments.” If so, the fund would no longer qualify as a QDIA under the final rule.
Funds that use positive or negative screening may similarly result in their disqualification as a QDIA, if the screening involves non-pecuniary factors that effectively results in the exclusion of certain sectors or categories of investments, and such exclusions are reflected in the fund’s investment objectives or principal strategies. If these exclusions are not reflected in the investment alternative’s objectives or principal strategies, but they are otherwise disclosed, the fiduciary evaluating such fund is expected to undertake “an economic analysis of the economic consequences to the plan of such an exclusion and determining that such an exclusionary policy would not be economically harmful to the plan.”
The regulation does not apply to investment alternatives that are not designated investment alternatives under the plan (e.g., brokerage windows). However, DOL noted that the rule should not be construed as addressing the application of ERISA’s duties of prudence and loyalty to brokerage windows or other non-designated investment alternatives that grant participants and beneficiaries access to investments that are not designated investment alternatives, and suggests there may be future rulemaking to address this.
The DOL responded to concerns that the regulation may redirect or stall the development of ESG practices, particularly as the U.S. Securities and Exchange Commission (SEC) continues to monitor ESG developments. Commenters pointed to the SEC’s recent solicited public comment request on the “Names Rule” under the U.S. Investment Company Act of 1940, as amended. The DOL noted in the preamble to the final rule that it did not think it needed to delay a final rule until the SEC decides to take action on the Names Rule. The DOL also recognized that some financial regulators are looking at whether ESG risk presents systemic risk to the financial markets. The DOL responded, “if financial regulators adopt new rules or policies that affect financial market participants, that may create pecuniary or non-pecuniary considerations for plan fiduciaries apart from ERISA.” It isn’t entirely clear what the DOL meant by this. One interpretation is that other regulators’ interpretation of materiality can inform an ERISA fiduciary’s determination as to whether a particular factor is pecuniary or not under the final rule. Yet a contrary interpretation is that the DOL, by using the language “apart from ERISA,” intends to largely wall off the final rule from other regulators’ potentially increasing liberalization over what factors are material to investment return and risk.
The DOL likewise responded to commenters who raised concerns that this rulemaking would interfere with how other federal agencies were addressing ESG risks. For example, the DOL acknowledged that the State Department, Treasury Department, Commerce Department and Department of Homeland Security have taken positions on supply chain links to entities that engage in human rights abuses, including, for example, forced labor in China. Even though supply chain risk is an ESG factor, the DOL took the position that it sees no fundamental conflict between this final rule and positions regarding supply chain risk raised by other government agencies.
Somewhat relatedly, the DOL responded to a comment that the rule would conflict with the position it took regarding the federal Thrift Savings Plan (TSP), namely, to prohibit the plan from investing in Chinese equities. While noting that the TSP is not covered by Title I of ERISA, the DOL added that its “position with respect to investments in China was informed by consideration of specific matters relating to investment risk, including inadequate investor disclosures and legal protections, that are consistent with “pecuniary factors” as used in the final rule.” The DOL further added that “other concerns were raised because the Federal Government matches TSP contributions and investments in China might result in the Federal Government funding activities that are opposed to U.S. national security interest.” Its first explanation, namely that it found disclosures related to Chinese holdings insufficient and legal protections were insufficient, is noteworthy for all ERISA fiduciaries because the final rule states that sufficiency of disclosures and legal protections are pecuniary factors. Thus, a fiduciary may wish to exercise caution in how it evaluates and documents the pecuniary factors in deciding on an investment that has Chinese holdings in light of the DOL’s concern.
The DOL dismissed concerns that the final rule would conflict with international ESG rules and trends by dismissing the sheer relevance of such trends and non-U.S. rules. Specifically, the DOL stated, “international trends in the consideration of ESG factors or other actions of regulators in other countries are not an appropriate gauge for evaluating ERISA’s requirements as they apply to investments of ERISA-covered employee benefit plans.”
The final rule is not immune to rescission or change by Congress or the DOL under a future administration.
1 29 C.F.R. § 2550.404a-1.
2 In a footnote to the preamble of the final rule, the DOL stated, “[t]he Department notes that it may be that a fiduciary could prudently determine that the expected return balanced against the costs and risks of loss associated with divesting an investment made before the effective date of the rule are such that continuing to hold that investment would be appropriate even if the fiduciary as part of its monitoring process determined that the investment, or aspects of the decision-making process, does not comply with the final rule.”
3 The proposal’s language seemingly required that, before an ERISA fiduciary could treat an ESG or other factor as a pecuniary factor, the ESG or other factor would already have had to be determined by other investment professionals as being material to investment performance.
4 In the preamble to the final rule, the DOL noted, for example, that “a company’s improper disposal of hazardous waste would likely implicate business risks and opportunities, litigation exposure, and regulatory obligations” and that “[d]ysfunctional corporate governance can likewise present pecuniary risk that a qualified investment professional would appropriately consider on a fact-specific basis.”
5 The DOL indicated that it does not intend the term “generally accepted investment theories” to freeze the evolution of investment theory or practice, but rather “to establish a regulatory guardrail against situations in which plan investment fiduciaries might be inclined to use…policy-based metrics in their assessment of the pecuniary value of an investment or investment plan that are inherently biased toward inappropriate overestimations of the pecuniary value of policy-infused investment criteria.”
In this webcast, we:
- Provide an overview of ESG and how the strategies apply to the various types of private fund managers.
- Give an update on the regulatory climate and legal developments for ESG from the US to Europe and Asia.
- Provide a framework for approaching the development of an ESG process, including where to access useful tools and resources.
Trysha Daskam, Director & Head of ESG Strategy, Silver Regulatory Associates
John P. Hamilton, Counsel, Stradley Ronon
George Michael Gerstein, Co-Chair, Fiduciary Governance, Stradley Ronon
In response to perceived abuses, and acknowledging the rapid growth in environmental, social & governance (ESG) investing, the U.S. Department of Labor (DOL) issued a highly-anticipated notice of proposed rulemaking that would clarify the circumstances under which ESG investing, including the selection of ESG funds in plan lineups, may be conducted in a manner that accords with the fiduciary duties under Section 404 of the U.S. Employee Retirement Income Security Act of 1974, as amended (ERISA). This proposal comes just two years after the DOL issued Field Assistance Bulletin (FAB) 2018-01. It is also part of a continuum of ERISA-ESG guidance over the decades, across both Democrat and Republican administrations, that has sought to address how ERISA’s stringent fiduciary duties may be satisfied when one or more E (e.g., climate change), S (e.g., employee relations) and or/G (e.g., corporate governance) factors are pursued either because they are material to investment performance or because they further some public policy or similar goal.
If the proposal is adopted as-is, plan sponsors, other fiduciaries and the industry, will face a tall order in incorporating ESG factors, especially in furtherance of policy or other non-financial goals (e.g., impact investing), with respect to both the (1) management of plan assets and (2) selection and monitoring of plan investment options available under individual account plans, as the case may be. Here are the initial key takeaways:
- Integration: ESG strategies, such as integration, that incorporates one or more E, S and/or G factors because of materiality to investment performance, would still be considered consistent with ERISA’s fiduciary duties, provided: (a) there is documentation as to the basis for the materiality determination; (b) other “qualified investment professionals” (i.e., an objective standard) would similarly conclude that the ESG factor is material to investment performance based on “generally accepted investment theories”; (c) the weight given to the ESG factor in the materiality analysis is appropriate (a point the DOL stressed in FAB 2018-01); and (d) the ESG investment is measured against “other available alternative investments” with respect to diversification, liquidity and potential risk-return of the plan portfolio. Point (d) is perhaps the biggest deal because it is arguably de facto the tie-breaker test, which the DOL historically used only when the ESG factor was not material to investment performance, and will raise compliance risk for ERISA fiduciaries (investment managers may be able to mitigate this risk through representations from the appointing fiduciary). The DOL noted in the preamble that this requirement was intended to clarify “that an investment or investment course of action must be compared to available alternatives [and] is an important reminder that fiduciaries must not let non-pecuniary considerations draw them away from an alternative option that would provide better financial results.”
- Other types of ESG investment strategies: The DOL technically allows an ERISA fiduciary to select an ESG investment, in whole or part, for non-financial/pecuniary reasons, which is in keeping with their long-standing guidance. However, the DOL tightens the screws by requiring that the investments be pursued only if they are “economically indistinguishable” from non-ESG investments, and the fiduciary documents such basis “based on the purposes of the plan, diversification of investments, and interests of plan participants and beneficiaries in receiving benefits from the plan.” There are two immediate considerations: (a) how does “economically indistinguishable” standard differ from the tie-breaker test that the DOL historically used in these contexts? and (b) can these conditions ever be met if the investment is pursued partly for non-pecuniary reasons but, as the DOL acknowledges (referencing Dudenhoeffer), the interests of participants and beneficiaries are in pecuniary benefits? In terms of the former, the DOL’s intent is that there is no difference; in terms of the latter, the DOL acknowledges that this standard would only be met in exceedingly rare circumstances, a position that harkens back to the DOL’s 2008 ESG guidance. Because the DOL believes a fiduciary finding that an ESG investment is economically indistinguishable from a non-ESG investment to be a rare occurrence, it does not believe the aforementioned documentation requirements will be a significant cost to the industry.
- Individual Account Plans: The plan may offer an ESG investment alternative, including an ESG-themed fund, to participants, subject to these two conditions: (a) “the fiduciary uses (and documents using) only objective risk-return criteria, such as benchmarks, expense ratios, fund size, long-term investment returns, volatility measures, investment manager investment philosophy and experience, and mix of asset types” in selecting and monitoring the fund; and (b) no ESG fund is added as, or as a component of, a QDIA. Consequently, “fiduciaries considering investment alternatives for individual account plans should carefully review the prospectus or other investment disclosures for statements regarding ESG investment policies and investment approaches.” The first condition would eliminate the possibility of adding an ESG fund to a plan lineup for any reason other than those investment-return related criteria, such as to promote a public policy (e.g., climate change, etc.). Commenters should seek clarification from the DOL as to whether this was their intent. The second condition is plain on its face and is equally significant: any ESG-related QDIA, regardless of whether it’s a themed fund, and irrespective that just one component of the QDIA takes ESG into account, is out, even if the ESG fund is selected for the plan solely on the basis of investment performance materiality. It’s unclear if this exclusion is limited to ESG funds whose objectives include non-pecuniary ESG goals or whether it applies to all types of ESG funds.
- The DOL cautioned that “fiduciaries should also be skeptical of “ESG rating systems” – or any other rating system that seeks to measure, in whole or in part, the potential of an investment to achieve non-pecuniary goals – as a tool to select designated investment alternatives, or investments more generally.”
- The proposed rule, if adopted, would take effect 60 days after publication in the Federal Register, though the DOL is open to comment on whether transition relief should be available.
- ESG funds and products that have short track records, low assets under management, and/or are somewhat more expensive than similar non-ESG funds, will be particularly vulnerable under this proposal.
- As noted above, there is a 30-day comment period for this proposal.