ARTICLE
8 November 2024

The New Battleground In The Fight Over ESG's Role In Public Pension Investments: The Courtroom

RG
Ropes & Gray LLP

Contributor

Ropes & Gray is a preeminent global law firm with approximately 1,400 lawyers and legal professionals serving clients in major centers of business, finance, technology and government. The firm has offices in New York, Washington, D.C., Boston, Chicago, San Francisco, Silicon Valley, London, Hong Kong, Shanghai, Tokyo and Seoul.
As we discussed in our 2023 white paper "ESG and Public Pension Investing in 2023: A Year-to-Date Recap and Analysis", there was a surge in legislative activity in 2023...
United States New York Oklahoma Texas Employment and HR

As we discussed in our 2023 white paper "ESG and Public Pension Investing in 2023: A Year-to-Date Recap and Analysis", there was a surge in legislative activity in 2023 among red states curtailing the use of environmental, social and governance (ESG) factors by asset managers and pension officials with respect to the investment decisions of governmental plans.

This increase in anti-ESG legislation was driven in part by the U.S. Department of Labor's (DOL) adoption of a regulation two years ago that expressly permits fiduciaries of ERISA-covered retirement plans to consider climate change and other ESG factors in investment selection, and in part, by the enactment of legislation in blue states to divest their retirement plans from certain industries like fossil fuel and firearms.

Compared to last year, 2024 has seen a significant drop-off in state ESG-related legislation, with half the number of bills proposed and a quarter of the number of bills enacted (See our 2024 mid-year review for additional analysis of these trends). This decline might come as a surprise, given that the initiatives motivating last year's wave of activity have not abated—but a closer look reveals that the battleground has arguably shifted from the statehouse to the courtroom as more of these laws have been challenged for their enforceability.

At the same time, the fate of the DOL's ESG rule hangs in the balance in the Northern District of Texas, where attorneys general from 26 states have sued the DOL seeking to invalidate the regulation. The ultimate resolution of that case could play a big role in predicting the future of litigation in this space.

New York

The first attempt to challenge a state or local law addressing ESG policies in the public pension space came in May 2023, when participants in the New York City Retirement System sued three city pension funds, claiming the trustees' decision to divest from fossil fuel investments violated their fiduciary duties. According to their lawsuit, which was sponsored by the Americans for Fair Treatment, a conservative anti-union organization, "[t]his unlawful decision to elevate unrelated policy goals over the financial health of the plans is flatly inconsistent with the defendants' fiduciary responsibilities and jeopardizes the retirement security of plan participants and beneficiaries."

In July 2024, a New York state trial court granted the pension plans' motion to dismiss the litigation, finding that in accordance with U.S. Supreme Court precedent in Thole v. U.S. Bank N.A., 590 U.S. 538 (2020), the plaintiffs lack Article III standing to challenge the divestment decisions because the plans are "defined benefit" pension plans. As the decision explained, "the plaintiffs are entitled to a fixed benefit each month and will receive the same amount regardless of whether they win or lose this action...just like the plaintiffs in Thole, plaintiffs here have not, and will not, suffer any monetary losses based upon defendants' investment decisions." Since the case was decided on procedural standing grounds, the court was not required to address the underlying merits of the plaintiffs' claims, and the plaintiffs' anti-ESG fiduciary duty theory remained untested. Any substantive ruling on the merits of fossil fuel divestment could have wider impacts on asset managers.

Oklahoma

On the other end of spectrum has been the fight over Oklahoma's controversial anti-boycott law, the Oklahoma Energy Discrimination Act of 2022. The statute prohibits the state's public retirement plans from investing in companies that "boycott" fossil fuel producers. Under the law, the Oklahoma Treasurer is charged with compiling a list of companies he believes to be engaged in boycotting (as broadly defined in the legislation), while any financial institution doing business with the state must verify in writing that it does not and will not boycott energy companies. Unlike similar statutes adopted in other states, the Oklahoma law permits fiduciaries to continue to hold investments with declared boycotters if they determine it would be imprudent to divest, and this fiduciary override has already been exercised in certain circumstances.

In November 2023, a former state employee and beneficiary of the Oklahoma Public Employees Retirement System sought a temporary restraining order against the Oklahoma Treasurer regarding its restricted financial institutions list. Among other claims, the suit alleged that the Treasurer's actions violated the First Amendment of the U.S. Constitution as well as its state analog, noting how the Oklahoma Constitution "requires state managed pension systems to operate for the 'exclusive benefit' of their beneficiaries...and that "[t]he state's decision to use its retirees' retirement funds as political fodder in its quixotic quest to prove a point is patently unconstitutional and violates federal law." The lawsuit, which was backed by a coalition that included the Oklahoma Public Employees Association, represented the first such suit brought by a plan participant challenging a boycott law anywhere in the United States.

An Oklahoma County District Court judge issued a temporary injunction in May 2024 blocking enforcement of the law after finding that the plaintiff was likely to succeed in his lawsuit. In her ruling, Judge Sheila Stinson said the Oklahoma Constitution requires retirement funds to be managed for the exclusive benefit of their beneficiaries, but the law appears aimed at countering certain political agendas and helping the oil and gas sector. Judge Stinson also said the law contains conflicting and unclear definitions for key terms. In July, Judge Stinson issued a permanent injunction against enforcement of the Oklahoma law. The state attorney general has appealed the ruling to the state appellate court.

The reasoning behind the judge's decision to grant the injunction could resonate in lawsuits targeting similar anti-boycott laws in other states (i.e., Texas, as discussed below), where similar fiduciary obligations apply to those responsible for overseeing public pension assets.

Texas

On August 29, 2024, the American Sustainable Business Council (ASBC), an organization that promotes sustainable investing and manufacturing, sued Texas state officials, seeking to block enforcement of another anti-boycott statute in favor of energy companies similar to the one at issue in Oklahoma. The law, SB 13, which took effect in 2021, requires the State Comptroller's office to maintain a list of all financial companies that, in the Comptroller's opinion, refuse to deal with, terminate business activities with, or otherwise take any action that is intended to penalize, inflict economic harm on, or limit commercial relations with fossil fuel companies, without an ordinary business purpose for doing so. The law applies to investments by state pension funds as well as state government contracting.

The suit was filed in the Western District of Texas, and names Texas Comptroller Glenn Hegar and Texas Attorney General Ken Paxton as defendants. It seeks to have SB 13 declared unconstitutional and the officials permanently enjoined from enforcing it. The complaint argues that SB 13:

  1. Violates First Amendment free speech rights because, on its face and as interpreted and applied by the Comptroller, it discriminates against financial companies and would-be government contractors on the basis of the content and viewpoint of their speech (moreover, SB 13 unconstitutionally compels other speech by requiring companies to verify agreement with Texas's preferred position regarding fossil fuels as a condition of managing investments for or contracting with state entities);
  2. Amounts to an unconstitutional infringement on First Amendment freedom of association rights because being a member of climate coalitions such as the Net Zero Asset Managers Initiative, Climate Action 100, or the Net Zero Banking Alliance potentially represents a form of "boycott[ing] energy companies," resulting in state entities being unable to invest or contract with ASBC members;
  3. Is unconstitutionally vague and overbroad because it does not adequately define "action that is intended to penalize, inflict economic harm on, or limit commercial relations with a company because the company" is in the fossil fuel industry or does business with a company in the fossil fuel industry; and
  4. Violates Fourteenth Amendment due process rights because it encourages arbitrary enforcement and fails to give regulated entities fair notice of prohibited conduct.

The complaint also alleges that two members of ASBC had their "flagship investment funds" placed on a state "blacklist."

While the arguments the plaintiffs present are different from those raised by the Oklahoma plan participant, this lawsuit comes on the heels of a successful First Amendment challenge by private businesses against Florida's Stop WOKE Act, which did not cover state investments but more directly circumscribed the types of DEI trainings private businesses could conduct. The ASBC's theory of harm is similar to the one argued in the Stop WOKE Act suit, that private businesses should be permitted to take the position of their choosing on complex social and political issues, and that their inability to do so would be harmful to their legitimate business interests. In the Texas litigation, ASBC is arguing that the inability to invest in funds that consider climate risk is detrimental to their business interests.

Whether this theory will succeed in court is unclear. The injunction against the Stop WOKE Act was upheld on appeal by a unanimous panel of judges, including two appointed by Former President Donald Trump. However, that challenge was based on direct viewpoint-based speech restrictions, while the anti-boycott provisions in SB 13 direct the state on how to grant contracts and invest state funds. Nonetheless, the plaintiff's First Amendment arguments are strong, showing a clear preference by state law for financial companies that take a pro-oil and gas position.

DOL Rule

As mentioned above, overlaying the challenges to the different state ESG laws is the ongoing fight over the DOL's ESG Rule in the Northern District of Texas. In this case, a coalition of state attorneys general filed suit in 2023 against the DOL over its ESG rule, which allows, but does not require, ERISA plan fiduciaries to consider ESG factors as a tiebreaker (i.e., a "collateral factor") in deciding between two otherwise equal investments. The DOL achieved a surprising win in September 2023 when the court granted its motion for summary judgment, finding that it was entitled to Chevron deference. The states appealed to the Fifth Circuit, but after the Supreme Court overturned its longstanding Chevron doctrine in Loper Bright Enterprises v. Raimondo, 144 S. Ct. 2244 (2024), the Fifth Circuit vacated the district court's original decision and remanded the case for further consideration on the merits.

In their brief for the remanded case, the states maintain their Administrative Procedure Act arguments from the original case but add several arguments about the interpretation of ERISA, including:

  • There can be no tiebreaker because when choosing between two investments, ERISA requires fiduciaries to purchase both investments for diversification;
  • The common law duty of loyalty forbids mixed motives, even when the other motive is harmless, and the Supreme Court's past interpretation of "sole and exclusive benefit" reaches the same conclusion;
  • The ESG rule violates the major questions doctrine, as ERISA plans hold $13 trillion in assets and this rule brings about radical change in how the plans are managed;
  • ERISA has specific carveouts in its fiduciary duties (e.g. letting corporate officers serve as ERISA trustees), and the absence of a specific ESG carveout indicates that Congress did not intend to create one;
  • The DOL's past practice conflicts with Congress's stated intent (through its disapproval resolution); and
  • Congress considered, and declined to adopt, several proposals to permit fiduciaries to engage in socially oriented investing.

The DOL made the following arguments in response:

  • The overturning of Chevron doesn't change the district court's conclusions that the major questions doctrine doesn't apply and the state plaintiffs probably do not have standing;
  • So-called "Skidmore" deference still applies, allowing deference to agency interpretations based on their persuasiveness, and the district court should consider the DOL's interpretation;
  • The tiebreaker provision already has built-in guardrails under ERISA's duties of loyalty and prudence; and
  • In the event of a tie, it may not always be prudent to choose both investments – e.g., if there are additional transaction or monitoring costs involved.

Conclusion

Over the last few years, the ESG debate has brought about a growing divergence between the federal standards under ERISA and various state laws that address the duties and responsibilities of fiduciaries when it comes to plan investment decision-making. We are now beginning to see how courts analyze these laws and whether or not such laws can survive challenge.

Further Information on State ESG Regulation

Be sure to check out our award-winning interactive website, Navigating State Regulation of ESG Investments, which tracks the latest ESG-related legislation, executive actions and initiatives, and coalition activities, as well as changes to state retirement plan investment policies across the United States. In addition, the website offers a variety of podcasts and memos to provide users with easy access to our team's key insights in understanding this dynamic area.

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.

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