United States: Do We Finally Have A Final Answer On ESG Investments And ERISA's Fiduciary Duties?

Seyfarth Synopsis: At the end of November, the DOL issued final regulations on ERISA's fiduciary duties when investing plan assets. According to the DOL, these final regulations retain the longstanding core principles that an ERISA fiduciary must focus on the relevant risk-return factors when evaluating plan investments, and the fiduciary duty to manage plan assets includes managing (and potentially exercising) the rights associated with ownership of such assets (e.g., proxy voting). As we've covered on our blog over the last several years, the DOL's guidance concerning ERISA's fiduciary duties and responsibilities when evaluating plan investments and the potential role of environmental, social and governance (ESG) factors in that analysis has changed significantly. (See our prior blog posts here, here, here, and here for more on the complicated history.)

Evolution of DOL Guidance on ESG

Over the years, the DOL has provided guidance concerning ERISA's fiduciary duties and responsibilities when investing plan assets, including the role of factors that are arguably non-economic or "non-pecuniary" (e.g., ESG or sustainability factors) in those duties. The DOL's guidance on this topic has evolved and varied over time as the economic environment and administrations have changed.

2015

In Interpretive Bulletin 2015-01 (IB 2015-1), the DOL allowed that a fiduciary could make investment decisions considering non-pecuniary factors, such as ESG, as "tie breakers" — i.e., the expected risk-return characteristics of alternative proposed investments are the same. Further, the DOL acknowledged that when the fiduciary prudently determined that the investment is justifiable based solely on its economic considerations, then there is no need to evaluate collateral factors as tie breakers. In that bulletin, however, the DOL also acknowledged that in some cases ESG may have a direct relationship with the economic and financial value of the plan's investment. In those instances, ESG factors are not merely collateral considerations or tie breakers, but rather are a proper component of the fiduciary's analysis of the economic merits of competing investment choices.

2018 through 2020

In Field Assistance Bulletin 2018-01 (FAB 2018-01), the DOL appeared to limit IB 2015-1 by warning fiduciaries against taking an expansive view on whether ESG factors are economically relevant to a prudent investment selection. That same administration in June 2020 followed up with proposed regulations addressing the topic. Those regulations indicated that ERISA fiduciaries should focus on "pecuniary" factors when evaluating an investment or investment strategy, and it cast doubt on whether ESG factors could meet that standard. The same DOL also then issued proposed rules in August 2020 regarding a fiduciary's responsibility when exercising shareholder rights (including voting proxies) associated with the plan's assets.

When both of those rules were finalized and published in November and December 2020, they indicated that plan fiduciaries must evaluate investments and investment strategies based solely on "pecuniary" factors; made it clear that the DOL was skeptical that ESG factors were pecuniary in nature; and severely restricted a fiduciary's ability to vote proxies for the plan's assets.

2021 through 2022

The current administration announced in March 2021 that it would not enforce the 2020 regulations and subsequently issued proposed regulations revising those rules. Those proposed regulations continued to emphasize the importance of the risk-return analysis of a proposed investment, but they also made it clear that such an analysis could include evaluating the potential economic effects of climate change and other ESG factors on the proposed investment. Those proposed regulations were finalized in November 2022, which we discuss below.

Longstanding Principles Affirmed

In the preamble to the final regulations, the DOL emphasized that the final rule does not change the following "longstanding principles":

• ERISA's duties of prudence and loyalty require ERISA fiduciaries to focus on risk and return factors when investing plan assets; and
• An ERISA fiduciary's duty to manage plan assets includes exercising rights associated with those assets (e.g., proxy voting).

ERISA's Loyalty and Prudence Duties

The regulation provides that an ERISA fiduciary will satisfy ERISA's duties of loyalty and prudence when considering an investment or investment course: (a) if the fiduciary has given "appropriate consideration" to the facts that the fiduciary "knows or should know" are relevant to that particular investment or investment course, and (b) acts accordingly. For this purpose, "appropriate consideration" includes:

• The fiduciary determines that the investment or investment course of action is reasonably designed to further the plan's purpose when considering the potential risk and return compared to the potential risk and return of reasonably available alternatives; and
• For plans that are not participant-directed plans (e.g., not 401(k) plans), the fiduciary considers the following factors: the diversification of the portfolio; the liquidity and current return of the portfolio relative to the plan's anticipated cash flow requirements; and the projected return of the portfolio relative to the plan's funding objectives.

In the preamble, the DOL indicates that the new language in the final rule establishes the following three principles:

• A fiduciary's decision must be based on the factors that the fiduciary "reasonably determines are relevant to a risk and return analysis, using appropriate investment horizons consistent with the plan's investment objectives and taking into account the funding policy of the plan".
• The risk and return factors may include the economic effects of climate change and other ESG factors.
• The weight given to any factor "should appropriately reflect an assessment of its impact on risk and return".

The preamble also confirms that, under the final rule, an ERISA fiduciary is not required to consider ESG factors when making an investment decision. This is a change from the proposed regulations which (at the very least) suggested that an evaluation of ESG factors was required when evaluating an investment or investment course of action.

The 2020 final rule included special documentation requirements when a fiduciary decided that alternative investments were economically indistinguishable and the fiduciary "breaks the tie" by relying on other factors. The new 2022 final rule eliminated those special requirements because the DOL concluded that they were unnecessary given that the existing ERISA fiduciary duties and responsibilities are commonly understood to include documenting investment decisions.

Defined Contribution Plans

The final rule includes some minor changes to clarify how ERISA's loyalty and prudence duties apply to participant-directed defined contribution plans (e.g., 401(k) plans). The DOL cautions in the preamble that these clarifications do not suggest that a lower standard applies when a fiduciary of a participant-directed defined contribution plan is making an investment decision. Also in the preamble, the DOL agreed with a commentor that the relevant analysis when constructing a menu of investment options for such a plan involves answering the following:

The DOL regulation also includes special guidance with respect to the duty of loyalty for such fiduciaries. Specifically, a fiduciary does not breach ERISA's duty of loyalty solely because the fiduciary considers preferences expressed by participants in a manner consistent with the fiduciary's duty of prudence. The DOL justified including this new provision by noting that accommodating participant stated preferences could increase participation and ultimately lead to greater retirement security. This does not mean, however, that a fiduciary may add (or continue to offer) an imprudent investment option in a participant-directed plan that participants prefer. According to the preamble, this new language does not reflect a change in the DOL's position.

The final rule retains the rescission of the prior prohibition against a qualified default investment alternative ("QDIA") or any component of the QDIA from having any "investment objectives, goals, or principal investment strategies that include, consider, or indicate the use of one or more non-pecuniary factors in its investment objectives". According to the preamble, the DOL now believes that such a requirement would not protect plan participants and could only serve to harm participants. The DOL does caution that selecting (and retaining) a QDIA continues to be subject to the same fiduciary duties and responsibilities under the final rule as all other investments.

Exercising Shareholder Rights

In the final regulation, the DOL recognizes that the "fiduciary act of managing plan assets includes the management of voting rights (as well as other shareholder rights) appurtenant to shares of stock." It also emphasizes that the fiduciary duty to manage plan assets includes exercising the shareholder rights associated with those assets, and fiduciaries should exercise those rights to protect the plan's interests. As a result, fiduciaries should weigh the cost and effort of voting proxies (or exercising other shareholder rights) against the significance of the issue to the plan. In addition, consistent with the proposal, the final regulation:

• Eliminates several provisions that were previously couched as "safe harbors" because the DOL was concerned that fiduciaries would believe they had permission to abstain from voting proxies without properly considering the plan's interests as a shareholder; and
• Prohibits a fiduciary from following the recommendations of a proxy advisory firm or other service provider unless the fiduciary determines that the firm or other service provider's proxy voting guidelines are consistent with ERISA's fiduciary duties and responsibilities.

Plans Covered by Final Regulation

It is important to remember that this regulation only applies to plans that are subject to ERISA's fiduciary duties and responsibilities for investing plan assets. As a result, they do not apply to: plans excluded from ERISA (e.g., governmental plans, church plans that have not elected to be covered under ERISA); plans without assets (e.g., unfunded welfare plans); and plans that are not subject to ERISA's fiduciary rules (e.g., supplemental executive retirement plans, "top hat" deferred compensation plans).

Conclusion

With these final regulations: we are still left with the question of whether it is ill-advised for plan fiduciaries to engage in "ESG investing" especially for those investments based solely on ESG considerations. While the final rule acknowledges that ESG factors may be appropriate factors to consider in the risk and return analysis, with the continued proliferation of class-action litigation attacking plan fees and investment selections for participant-directed defined contribution plans, a properly structured fiduciary process (including appropriate documentation of that process) remains a must.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.