DOL Proposes Rule on ESG Investments and Proxy Voting

Practical Law Legal Update w-033-0004 (Approx. 9 pages)

DOL Proposes Rule on ESG Investments and Proxy Voting

by Practical Law Employee Benefits & Executive Compensation

ESG Investments

ESG investments are investments that are selected, in part, for their collateral economic or social benefits. While retirement plans have begun to utilize ESG factors in making their investment offering decisions, questions have been raised for many years on whether plan investments in ESGs are compatible with ERISA's fiduciary standards under ERISA Sections 403 and 404 (29 U.S.C. §§ 1103 and 1104), which require that a fiduciary:

Act prudently.
Act solely in the interest of plan participants and beneficiaries.
Act for the exclusive purpose of providing benefits to participants and beneficiaries.
Diversify plan investments so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent to not do so.

For more information on ERISA's fiduciary standards, see Practice Note, ERISA Fiduciary Duties: Overview.

Past Guidance on ESG Investments and Proxy Voting

The DOL has been asked to consider the application of the rules under ERISA to investments in ESGs because of the non-pecuniary benefits ESG investments further.

The DOL's first guidance addressing ESG investment issues was Interpretive Bulletin 94-1 (IB 94-1) (59 Fed. Reg. 32606 (June 23, 1994)). In IB 94-1, the DOL explained that the requirements of ERISA Sections 403 and 404 do not prevent fiduciaries from investing in ESGs if:

The investment has an expected rate of return commensurate to rates of return available with alternative investments with similar risk characteristics.
The investment vehicle is otherwise an appropriate investment for the plan in terms of such factors as diversification and the investment policy of the plan.

This has been referred to as the "all things being equal" test or the "tie-breaker test." When competing investments serve the plan's economic interests equally well, plan fiduciaries can use such non-pecuniary considerations as the deciding factor for an investment decision.

IB 94-1 was replaced with Interpretive Bulletin 2008-1 (IB 2008-1) (73 Fed. Reg. 61734 (Oct. 17, 2008)). In 2015, the DOL replaced IB 2008-1 with Interpretive Bulletin 2015-01 (IB 2015-01) (80 Fed. Reg. 65135-01 (Oct. 26, 2015; see Legal Update, For Plan Investments in ETIs, the All Things Being Equal Test Prevails (Again)). All of the IBs emphasized that:

The plan fiduciary's focus must be on the plan's financial returns.
Furthering the interest of plan participants and beneficiaries under the plan is of the utmost importance.

Each IB restates the "all things being equal" test, but the DOL has cautioned that fiduciaries still can violate ERISA if they accept reduced returns or greater risk to secure social, environmental, or other public policy goals.

In IB 2015-01, the DOL explained that if a fiduciary prudently determines that an investment is appropriate based on economic considerations, including those that may derive from ESG factors, the fiduciary may make the investment without regard to any collateral benefits the investment may promote. The DOL notes that in these situations:

The issues are appropriate economic considerations, and thus may be considered by a prudent fiduciary along with other relevant factors to evaluate the risk and return profiles of different investments.
The factors are not "tie-breakers" but pecuniary factors affecting the economic merits of the investment.

Most recently in FAB 2018-01, the DOL made clarifications to IB 2015-01 (see Legal Update, In FAB 2018-01, DOL Clarifies Its Views on Proxy Voting, Shareholder Engagement, and Plan Investments in ETIs).

In June 2020, under the Trump administration, the DOL issued a proposed rule intended to clarify when selecting ESG investments can be achieved in accordance with ERISA's fiduciary duties (85 Fed. Reg. 39113-02 (June 30, 2020); see Legal Update, DOL Issues Proposed Rule on Environmental, Social, and Governance (ESG) Investing for Retirement Plans). The final was substantially similar to the proposed rule, but omitted the ESG terminology (see Legal Update, Final DOL Rule Addresses Use of Non-Financial Factors in Selecting Retirement Plan Investments).

In December 2020, the DOL issued final regulations addressing fiduciary duties under ERISA as they relate to voting of proxies on securities held in employee benefit plan investment portfolios and exercising other shareholder rights (see Legal Update, DOL Issues Final Regulation on Voting of Proxies on Securities Held in Employee Benefit Plan Investment Portfolios). Among other things, the final proxy voting rule expressly stated that the fiduciary duty to manage shareholder rights does not require the voting of every proxy or the exercise of every shareholder right.

After the change in administration, and in response to President Biden's Executive Order 13990, Protecting Public Health and the Environment and Restoring Science to Tackle the Climate Crisis, the DOL announced that it would not enforce the final investment and proxy voting rules (see Legal Update, DOL Announces It Will Not Enforce Recently Issued Final Rules on ESG Investments and Proxy Voting).

Proposed Rule

According to the DOL, the 2020 final investment rule had a chilling effect on the plan fiduciary's use of ESG factors such as climate change when making investment decisions. While the proposed rule retains much of the current regulations, the proposed changes are intended to clarify that fiduciaries may, when appropriate, consider ESG factors when making plan investment decisions and remove the negative perception associated with ESG factors. The proposed rule also makes certain changes to the proxy voting provisions.

Duty of Prudence

The proposed rule would amend the prudence provisions of Section 2550.404a-1 to clarify that:

Fiduciaries may need to consider climate change and other ESG factors when comparing a portfolio's projected return with the plan's funding objectives.
Fiduciaries may consider any factor, including climate change and other ESG factors, that is material to the risk-return analysis when making plan investment decisions. Examples of such ESG factors include climate change, governance, and workforce practices.

(See Practice Note, ERISA Fiduciary Duties: Overview: Duty of Prudence.)

Duty of Loyalty

The proposed rule would make several changes to the duty of loyalty provisions of Section 2550.404a-1, including incorporating ESG factors into the factors a fiduciary may need to consider, depending on the facts and circumstances, when making investment decisions (see Practice Note, ERISA Fiduciary Duties: Overview: Duty of Loyalty).

The proposed rule would also make changes to the tie-breaker standard. Under the current tie-breaker standard, when fiduciaries cannot distinguish between competing investments solely based on pecuniary factors, they can use non-pecuniary considerations as the deciding factor for an investment decision. The proposed rule would replace the tie-breaker standard with one that, in the DOL's view, better aligns with its prior nonregulatory guidance.

Under the proposed rule, if competing investments equally serve the plan's financial interests, fiduciaries are not prohibited from selecting an investment based on collateral benefits provided the following requirements are met:

If the fiduciary uses a collateral benefit when selecting a designated investment alternative for an investment account plan, the collateral benefit must be prominently displayed in the disclosure materials provided to participants and beneficiaries.
The fiduciary does not accept lower returns or higher risks to obtain the collateral benefit.

The proposed rule would also eliminate the documentation requirement that applies if fiduciaries use a collateral benefit when deciding between competing investment choices under the tie-breaker rule.

Regarding participant-directed individual account plans, the proposed rule would eliminate the rule that prohibits an investment fund, product, or model portfolio from being used as a qualified default investment alternative (QDIA) if its objectives, goals, or principal investment strategies indicate that it uses non-pecuniary factors (see Practice Note, Qualified Default Investment Alternatives (QDIAs)).

Proxy Voting and Exercising Shareholders Rights

Regarding fiduciary duties as they relate to voting of proxies on securities held in employee benefit plan investment portfolios and exercising other shareholder rights, the proposed rule would extend the fiduciary's duty of prudence and loyalty to include monitoring service providers, including investment managers and proxy advisory firms, that exercise shareholder rights on behalf of the plan. Additionally, the proposed rule would eliminate:

The statement that the fiduciary duty to manage shareholder rights does not require the voting of every proxy or the exercise of every shareholder right.
The specific monitoring requirement that applies if authority to vote proxies or exercise other shareholder rights has been delegated to an investment manager, proxy voting firm, or other advisor. In the DOL's view, the monitoring requirement under ERISA's general duties of prudence and loyalty is sufficient.
The two safe harbors under which a fiduciary may satisfy its fiduciary responsibilities for decisions on whether to vote proxies by adopting either, or both, of the following policies:
- 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
- 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).
(29 C.F.R. § 2550.404a-1(e)(3).)
The requirement to maintain records on proxy voting and other exercises of shareholder rights.

The proposed changes to the proxy voting provisions reflect the DOL's concern that the current regulations may be viewed as permission for fiduciaries to be indifferent or abstain from voting without fully considering the exercise of their rights as shareholders.

Effect on Health and Welfare Plans

The proposals regarding the proxy voting provisions would impact ERISA health and welfare plans that hold corporate stock. This would include:

Health plans that hold corporate stocks directly.
Stocks held by health plans that participate in certain ERISA-covered intermediary investment arrangements, for example:
- master trust investment accounts (MTIAs);
- common/collective trusts (CCTs);
- pooled separate accounts (PSAs); or
- 103-12 investment entities (103-12 IEs).

(For more information on these investment arrangements, which are referred to as "direct filing entities" (DFEs) when they file Form 5500 for an ERISA plan, see Practice Note, Form 5500 for Employee Benefit Plans: Overview: DFEs (Schedule D).)

Comments Requested

The DOL requested comments on various aspects of the proposed rule. Comments are due 60 days after publication in the Federal Register.

Practical Implications

The proposed regulations offer a significant change in direction from the Employee Benefits Security Administration and the DOL. Under the proposed regulations, ESG factors can be treated as important factors directly related to the risk and reward opportunity at hand. The proposal regulations also answer the question of whether ESG-focused investment options can be used an a retirement plan's QDIA.

DOL Proposes Rule on ESG Investments and Proxy Voting | Practical Law