On November 22, 2022, the U.S. Department of Labor (DOL) issued Final Rules that allow plan fiduciaries to consider climate change and other environmental, social and governance (ESG) factors when they select retirement investments and exercise shareholder rights, such as proxy voting.
After feedback from a wide range of stakeholders, the DOL concluded that two rules issued in 2020, during the prior administration, unnecessarily restrained plan fiduciaries’ ability to weigh ESG factors when choosing investments.
The new rules, “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” follow Executive Order 14030, signed by President Biden in May of 2021.
The Final Rules will be effective 60 days after their publication (January 30, 2023), except for a delayed applicability until one year after publication for proxy voting provisions to allow fiduciaries and investment managers additional time to prepare (December 1, 2023).
ERISA Fiduciary Standards
Title I of the Employee Retirement Income Security Act of 1974 (ERISA) establishes standards that govern the operation of private-sector employee benefit plans, including fiduciary responsibility rules. ERISA requires that plan fiduciaries act prudently and diversify plan investments to minimize the risk of large losses. ERISA also requires fiduciaries to act solely in the interest of the plan's participants and beneficiaries, and for the exclusive purpose of providing benefits to participants and beneficiaries and defraying reasonable plan expenses.
ERISA dictates that ERISA plan fiduciaries’ focus on a plan's financial returns must be paramount. For years, however, the DOL's non-regulatory guidance has recognized that ERISA does not preclude fiduciaries from making investment decisions that reflect ESG considerations and choosing economically targeted investments (ETIs). The DOL's non-regulatory guidance has also recognized that the fiduciary act of managing employee benefit plan assets includes the management of voting rights, as well as other shareholder rights, connected to shares of stock, and that management of those rights, as well as shareholder engagement activities, is subject to ERISA's prudence and loyalty requirements.
The DOL's Investment Duties Regulation was issued forty-five years ago under ERISA Section 404(a) (Investment Duties Regulation).
The DOL's Prior Non-Regulatory Guidance
The DOL has longstanding positions that ERISA fiduciaries may not sacrifice investment returns or assume greater investment risks to promote collateral social policy goals, under ERISA's stringent standards of prudence and that managing plan assets includes decision-making about exercising shareholder rights. Over the years the DOL has repeatedly issued non-regulatory guidance to assist plan fiduciaries in understanding their obligations under ERISA to apply these principles to ETIs and ESG investing.
In 1994, the DOL issued Interpretive Bulletin 94-1, stating that ETIs are not inherently incompatible with ERISA's fiduciary obligations if the investment has an expected rate of return at least commensurate to rates of return of available alternative investments and if the ETI is otherwise appropriate under ERISA and a plan’s investment policy. This was known as the “all things being equal” test or the “tiebreaker” standard, and was the DOL's unchanged position for the next three decades.
Exercising Shareholder Rights
The DOL first issued non-regulatory guidance on proxy voting and the exercise of shareholder rights in the 1980s, in which the DOL took the position that the named fiduciary of a plan has a duty to monitor decisions made by investment managers regarding proxy voting. In 1994, the DOL issued its first interpretive bulletin on proxy voting, Interpretive Bulletin 94-2 (IB 94-2). IB 94-2 recognized that fiduciaries may engage in shareholder activities intended to monitor or influence corporate management if the responsible fiduciary concludes that, after considering the costs involved, there is a reasonable expectation that such shareholder activities will enhance the value of the plan's investment.
In October 2008, the DOL replaced IB 94-2 with Interpretive Bulletin 2008-02 (IB 2008-02) to reflect interpretive positions issued by the DOL on shareholder engagement and socially directed proxy voting initiatives. IB 2008-02 stated that fiduciaries' responsibilities include both deciding to vote or not to vote proxies, and that fiduciary duties require consideration of only those factors that relate to the economic value of the plan's investments. It explained that if a fiduciary reasonably determines that the cost of voting (including the cost of research to determine how to vote) is likely to exceed the expected economic benefits of voting, the fiduciary has an obligation to refrain from voting. Finally, it emphasized that any use of plan assets by a plan fiduciary to further political or social causes “that have no connection to enhancing the economic value of the plan's investment” through proxy voting or shareholder activism is a violation of ERISA's exclusive purpose and prudence requirements.
In 2016, the DOL issued Interpretive Bulletin 2016-01 largely restating IB 94-2 that “in voting proxies, the responsible fiduciary [must] consider those factors that may affect the value of the plan's investment and not subordinate the interests of the participants and beneficiaries in their retirement income to unrelated objectives.”
Recent Evolution of DOL ESG/ETI Guidance
The DOL published proposed rules to remove prior non-regulatory guidance and to amend the Investment Duties Regulation to address perceived confusion about ESG considerations, ETIs, and the exercise of shareholder rights. The preamble to the 2020 proposals expressed concern that ERISA plan fiduciaries might be making improper investment decisions, and that plan shareholder rights were being exercised in a manner that subordinated the interests of plans and their participants and beneficiaries to unrelated objectives.
Less than six months later, the DOL published final rules (the Current Rules) amending the Investment Duties Regulation that generally requires plan fiduciaries to select investments based solely on consideration of “pecuniary factors,” including a prohibition against maintaining any investment fund as a qualified default investment alternative (QDIA) if the fund includes even one non-pecuniary consideration in its investment objectives and established standards for voting proxies or in exercising other shareholder rights in connection with plan investments.
In March of 2021, pursuant to President Biden’s Executive Order 13990, the DOL announced that it had begun a reexamination of the Current Rules and that, pending review, the DOL would not enforce the regulations; then, in May of 2021, President Biden signed Executive Order 14030, setting forth policies to mitigate climate-related financial risk and directed the DOL to consider publishing a proposed rule to suspend, revise, or rescind the Current Rules.
DOL Review of the Current Rules
In early 2021, the DOL engaged in informal outreach to hear views from interested stakeholders on how to craft regulations that better recognize the important role that climate change and other ESG factors can play in the management of plan investments. The DOL heard from a wide variety of stakeholders including asset managers, labor organizations and other plan sponsors, consumer groups, service providers, and investment advisers. Many of the stakeholders expressed skepticism as to whether the Current Rules properly reflect fiduciaries' duties to act prudently and solely in the interest of plan participants and beneficiaries.
The DOL concluded there is a reasonable basis for concern that the Current Rules appear to single out ESG investing for heightened scrutiny and that the Current Regulations may be deterring fiduciaries from taking steps that other marketplace investors would take in enhancing investment value and performance or improving investment portfolio resilience against the potential financial risks associated with climate change and other ESG factors (i.e., the Current Rules created a perception that fiduciaries are at risk if they include any ESG factors in the financial evaluation of plan investments, and that they would need to have special justifications for even ordinary exercises of shareholder rights).
The Proposed Rules
In October of 2021, the DOL published a notice of proposed amendments to the Current Rules (the Proposed Rules) to address uncertainties regarding the Current Regulations, including climate-related financial risk and investment and voting decisions, intended to safeguard the interests of participants and beneficiaries in plan benefits.
The Final Rules
The espoused purpose of the Final Rules is to clarify the application of ERISA's fiduciary duties of prudence and loyalty to selecting investments and investment courses of action, including selecting QDIAs, exercising shareholder rights (such as proxy voting), and the use of written proxy voting policies and guidelines.
The Final Rules generally track the Proposed Rules with clarifications and changes in response to public comments, consistent with (1) the duties of prudence and loyalty and (2) the duty to manage shareholder rights, such as voting proxies.
Summary of Major Changes
The Final Rules amend the Current Rules to:
- delete the “pecuniary/non-pecuniary” terminology based on concerns that the terminology causes confusion and a chilling effect on financially beneficial choices;
- clarify that a fiduciary's determination regarding an investment must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis, including the economic effects of climate change and other environmental, social, or governance factors;
- remove the stricter rules for QDIAs, so that the same standards apply to QDIAs as to other investments;
- permit fiduciaries to consider collateral benefits as a tiebreaker;
- remove the statement that “the fiduciary duty to manage shareholder rights appurtenant to shares of stock does not require the voting of every proxy or the exercise of every shareholder right.”;
- remove the two “safe harbor” examples for proxy voting;
- remove provisions setting out specific monitoring obligations with respect to the use of investment managers or proxy voting firms. The Final Rules address such monitoring obligations more generally;
- remove the specific requirement on maintaining records on proxy voting activities and other exercises of shareholder rights;
- replace the requirement that competing investments be indistinguishable based on pecuniary factors alone before fiduciaries can turn to collateral factors to break a tie with a standard that requires the fiduciary to conclude prudently that competing investments equally serve the financial interests of the plan;
- remove the special regulatory documentation requirements in favor of ERISA's generally applicable statutory duty to prudently document plan affairs; and
- clarify that fiduciaries do not violate their duty of loyalty solely because they take participants' preferences into account when constructing a menu of investment options for participant-directed individual account plans.
The Final Rules are Undoubtedly Not the Last Word
The Biden Administration believes that the Final Rules are neutral; and merely clarify the application of ERISA's fiduciary duties of prudence and loyalty in selecting investments and exercising shareholder rights. Republican legislators have, however, already introduced legislation to invalidate the Final Rules; and new administrations will likely have different views, making yet other course changes.
Source: Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights (Dec.1, 2022), available here.