ZACHARY ISENHOUR and ROBERT GOWER, November 29, 2022
On November 22, 2022, the United States Department of Labor (DOL) issued a new final rule (the “2022 Rule”) concerning climate change and environmental, social, and governance (ESG) considerations in selecting investments and exercising shareholder rights (including voting proxies) for plans subject to the Employee Retirement Income Security Act of 1974 (ERISA).1 The 2022 Rule reexamines the interplay between ESG and ERISA’s fiduciary duties of loyalty and prudence, relaxing the conditions under which it may be appropriate for plan fiduciaries to consider ESG factors when selecting investments and investment courses of action, and exercising shareholder rights (such as proxy voting). In doing so, the 2022 Rule enhances the ability for plan fiduciaries to consider ESG funds as prudent investment alternatives without running afoul of their fiduciary duties under ERISA.
The 2022 Rule is the (latest) culmination of over a decade’s worth of sub-regulatory and regulatory guidance wherein the DOL has gone back and forth on the extent to which, if at all, ESG factors can play a role in plan investments and the exercise of shareholder rights. Shortly after the last change in presidential administration, on January 20, 2021, President Biden directed agencies to review regulations published during the prior administration for potential negative or contradictory impacts on the Biden Administration’s climate-related initiatives. Such regulations included the Trump Administration’s 2020 ESG rule, which generally inhibited a fiduciary’s ability to prudently select ESG alternatives and created complex rules for voting proxies that implicated ESG concerns. Following an almost two-year regulatory process (including a Proposed Rule), the 2022 Rule curbs the course on the prior administration’s regulations, removing an exclusive focus on “pecuniary factors” and giving plan fiduciaries greater latitude to determine the appropriate investments for their particular plan and participant population.
Even with the significance of the changes, the DOL emphasizes that the 2022 Rule still rests on two core principles: (1) that ERISA’s duties of loyalty and prudence require fiduciaries to focus on relevant risk-return factors and not subordinate the interest of participants and beneficiaries to objectives unrelated to the provision of plan benefits; and (2) that fiduciary duties to manage plan assets consisting of shares of stock include exercising proxy rights appurtenant to those shares. Nevertheless, the 2022 Rule generally relies on obligations inherent in ERISA’s core duties of loyalty and prudence rather than mandating special considerations or documentation when ESG factors play a role.
Ultimately, the 2022 Rule is more welcoming to the consideration of ESG investments through four key changes:
- Elimination of Pecuniary Factors Requirement
The 2022 Rule abandons the distinction between “pecuniary/non-pecuniary,” as the DOL understood this distinction to have created a “chilling effect to financially beneficial choices,” leading plan fiduciaries to believe that any ESG considerations would be deemed non-pecuniary (or ancillary) in nature, and therefore imprudent. In removing the pecuniary factors requirement, the 2022 Rule provides that fiduciaries’ investment decisions “must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis.” The 2022 Rule states, without the elaboration seen in the Proposed Rule, that the economic effects of climate change and other ESG considerations may be appropriate factors, leaving such effects open for analysis and interpretation by plan fiduciaries on a case-by-case basis. Notably, the 2022 Rule provides that economic factors of climate change (among other ESG factors) may be relevant to an investment, or investment course of action, where the Plan’s investment policy provides for an investment horizon supportive of such consideration. For plan governance purposes, plan fiduciaries should take the DOL’s “risk and return” and “investment horizons” commentary into account when reviewing a Plan’s investment policy statement to potentially accommodate ESG. - ESG Factors Acceptable in a Qualified Default Investment Alternative (QDIA)
The 2022 Rule eschews special rules for fiduciaries considering ESG as a component of a QDIA. This departs from the prior administration’s rule which prohibited fiduciaries from designating a fund as a QDIA if it had investment objectives that included the use of non-pecuniary factors, even if the fund was objectively prudent from economic and risk/return perspectives. Rather, under the 2022 Rule, plan fiduciaries are to make decisions related to a QDIA under the same standards for other investments and the separate QDIA regulations. Notably, the 2022 Rule takes additional steps to further destigmatize ESG by no longer requiring an additional disclosure where ESG is a component of a QDIA, a requirement in the Proposed Rule that was the subject of significant public comment and concern. - Elimination of the “Tiebreaker” Rule
Under the prior regulation, a narrow exception called the tiebreaker rule generally permitted a fiduciary to consider ESG factors only when investments are indistinguishable on pecuniary factors, a situation that the preamble to the prior rule suggested was unlikely to occur. The 2022 Rule promulgates a standard that instead requires a fiduciary to conclude that competing investments “equally serve the financial interests of the plan over the appropriate time horizon.” The 2022 Rule implicitly allows a fiduciary to consider ESG and climate change factors when determining whether investments are equal (as long as those factors fit within the risk-return analysis). When investments are “equal,” a fiduciary may choose among investments based on collateral benefits. The 2022 Rule relies on ERISA’s generally applicable duty to document plan affairs rather than a special documentation requirement when ESG factors are relevant. - Participants’ Preferences
A new provision in the 2022 Rule clarifies that plan fiduciaries do not violate their duty of loyalty solely because they consider participants’ preferences (i.e., the desire or demand for an ESG investment alternative) when prudently selecting a menu of investment options. The preamble to the 2022 Rule contemplates that investment options that align with participants’ preferences may further the purpose of the plan where a menu of such options increases participation and deferral rates, leading to increased participation in the plan. This undoubtedly comes as welcome news for plan sponsors who have long struggled with participant requests for ESG alternatives in a complex framework of fiduciary responsibility.
The 2022 Rule also wrestles with the role of climate change and ESG factors when plan fiduciaries manage shareholder rights attached to investments held by the plan (proxy and other shareholder votes). The Biden Administration believes that the prior administration’s proxy voting regulations, which contain complex safe harbors, discourage plan fiduciaries from exercising their fiduciary duty regarding rights attached to the ownership of stock (much as the pecuniary factors test was seen to discourage consideration of ESG in investment selection). As such, the 2022 Rule eliminates the safe harbors in favor of a streamlined approach whereby fiduciaries are to consider exercising shareholder rights for the exclusive benefit of plan participants, including:
- Acting solely in accordance with the economic interest of the plan and its participants and beneficiaries;
- Considering any costs involved;
- Not subordinating the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to any other objective;
- Evaluating relevant facts that form the basis for any particular proxy vote or other exercise of shareholder rights; and
- Exercising prudence and diligence in the selection and monitoring of persons, if any, selected to exercise shareholder rights or otherwise advise on or 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.
Interestingly, the DOL comments that, while plan fiduciaries may adopt proxy voting policies, those policies must be reviewed periodically and are not immutable if a fiduciary reasonably determines specific circumstances require exercising (or not exercising) shareholder rights. With this in mind, plan fiduciaries should exercise careful and flexible drafting on any proxy voting policies (commonly contained in an investment policy statement).
Finally, under the 2022 Rule, plan fiduciaries, subject to the terms of the plan document and monitoring obligations, may also rely on a proxy advisory firm, investment manager, or pooled investment provider to exercise shareholder rights. Notably, the 2022 Rule requires managers of commingled funds (such as collective investment trusts) to harmonize proxy voting policies of benefit plan investors, which is likely to result in such managers developing policies for review and consent by plan sponsors.
In sum, the 2022 Rule favors a standard of reasonableness based on the facts and circumstances relevant to a particular plan over the bright-line rules for selecting investments and exercising shareholder rights found in the prior administration’s rules, aiming to allow plan fiduciaries more latitude when considering and selecting a menu of investment options or voting proxies.
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1 The 2022 Rule is awaiting publication in the Federal Register and a temporary version is available at the Department of Labor website: https://www.dol.gov/sites/dolgov/files/ebsa/temporary-postings/prudence-and-loyalty-in-selecting-plan-investments-and-exercising-shareholder-rights-final-rule.pdf
