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DOL Finalizes Rule on ESG Investments and Proxy Voting
Practical Law Legal Update w-037-6771 (Approx. 8 pages)
DOL Finalizes Rule on ESG Investments and Proxy Voting
by Practical Law Employee Benefits & Executive Compensation
| Law stated as of 28 Nov 2022 • USA (National/Federal) |
The Department of Labor (DOL) has issued final regulations that amend DOL Regulation Section 2550.404a-1 (29 C.F.R. § 2550.404a-1) to address when retirement plan fiduciaries may consider environmental, social, and governance (ESG) factors in selecting plan investments in accordance with their fiduciary duties under the Employee Retirement Income Security Act of 1974 (ERISA). The rule also addresses ERISA fiduciary duties as they relate to voting of proxies on securities held in employee benefit plan investment portfolios and exercising other shareholder rights.
On November 22, 2022, the DOL released a final rule that amends DOL Regulation Section 2550.404a-1 (29 C.F.R. § 2550.404a-1) to address when retirement plan fiduciaries may consider environmental, social, and governance (ESG) factors in selecting plan investments in accordance with their fiduciary duties under ERISA. The final rule also addresses ERISA fiduciary duties as they relate to voting of proxies on securities held in employee benefit plan investment portfolios and exercising other shareholder rights.
Background
ESG investments are investments that are selected, in part, for their collateral economic or social benefits. 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 ESG investments, see Practice Note, ESG Investments in Qualified Retirement Plans: Overview. For information on ERISA's fiduciary standards, see Practice Note, ERISA Fiduciary Duties: Overview.
Past Guidance on ESG Investments and Proxy Voting
2020 Guidance
In June 2020, under the Trump administration, the DOL issued a proposed rule on ESG investing (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 2020 rule was substantially similar to the proposed 2020 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 2020 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.
2021 Non-Enforcement and Re-Proposal
In March 2021, the DOL announced that it would not enforce the final investment and proxy voting rules from 2020 (see Legal Update, DOL Announces It Will Not Enforce Recently Issued Final Rules on ESG Investments and Proxy Voting). The announcement came after the change in administrations, and in response to President Biden's Executive Order 13990, Protecting Public Health and the Environment and Restoring Science to Tackle the Climate Crisis.
In October 2021, the DOL issued a proposed rule that would amend DOL Regulation Section 2550.404a-1 (29 C.F.R. § 2550.404a-1) to address ESG investments and proxy voting (see Legal Update, DOL Proposes Rule on ESG Investments and Proxy Voting). According to the DOL, the final 2020 investment rule had a chilling effect on the plan fiduciary's use of ESG factors, such as climate change, when making investment decisions.
The proposed 2021 rule 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.
For a complete history of the relevant guidance, see Practice Note, ESG Investments in Qualified Retirement Plans: Overview: DOL Sub-Regulatory and Regulatory Guidance.
Final Rule (November 2022)
The final 2022 rule generally follows the proposal, with a few notable changes discussed below. The DOL emphasizes that the final rule does not change two longstanding principles:
- The duties of prudence and loyalty require ERISA plan fiduciaries to focus on relevant risk-return factors and not subordinate the interests of participants and beneficiaries to unrelated objectives.
- The fiduciary duty to manage plan assets that are shares of stock includes the management of shareholder rights appurtenant to those shares, such as the right to vote proxies.
Investment Prudence
The final rule amends the investment prudence provisions of Section 2550.404a-1(b).
"May Often Require" Language Removed
The proposed rule stated that appropriate consideration of an investment portfolio "may often require" an evaluation of ESG factors. The "may often require" language is removed in the final rule. According to the preamble, the change clarifies that ESG factors do not need to be treated differently than other investment factors.
ESG Examples Removed
The proposed rule also included a list of example ESG factors that were appropriate for fiduciaries to consider when evaluating an investment. The examples included detailed climate change factors, corporate governance factors, and workplace practices. The final rule removes the list of examples. The final rule instead notes that factors relevant to the risk-return analysis "may include the economic effects of climate change and other environmental, social, or governance factors" but that whether any particular consideration is a risk-return factor "depends on the individual facts and circumstances."
Investment Loyalty Duties
The final rule amends the duty of loyalty provisions of Section 2550.404a-1(c).
Tie-Breaker Standard
The final rule adopts the changes to the tie-breaker standard. Under the current tie-breaker standard from 2020, 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. As with the proposal, the final rule removes references to "pecuniary/non-pecuniary" considerations. In a change from the proposal, the final rule removes the requirement that 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.
Qualified Default Investment Alternative (QDIA)
The 2020 rule prohibited 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)).
As with the proposal, the final rule removes that stricter limitation, so the same standards that apply to investments generally will apply to QDIAs.
Proxy Voting and Exercising Shareholder 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 final rule is substantially similar to the proposal, with some minor changes.
As proposed, the final rule eliminates:
- 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).
- The requirement to maintain records on proxy voting and other exercises of shareholder rights.
As with the proposal, the final rule 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 proxy voting provisions may impact ERISA health and welfare plans that hold corporate stock. This includes:
- 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).
Practical Implications
The final rule is effective and applicable 60 days after publication in the Federal Register, except for the applicability date of certain proxy voting provisions. The applicability date is one year after publication for:
- The requirement that fiduciaries may not adopt a practice of following the recommendations of a proxy advisory firm or other service provider without a determination that the firm's proxy voting guidelines are consistent with the fiduciary's obligations under the rule.
- The rules regarding investment policy statements for pooled investment vehicles.
The final regulations come after many years of shifting regulatory and sub-regulatory guidance on these issues. Plan fiduciaries and investment managers should familiarize themselves with the changes made in the final regulations.