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The Pendulum Swings Back: Final ESG Regulations Give Fiduciaries More Flexibility


Consideration of ESG investments can be a minefield for ERISA plan fiduciaries. There has long been a tension between the desire of some plan participants-especially younger ones- and some fiduciaries to make plan investments that take environmental, social and governance (ESG) factors into account and ERISA’s prudence, loyalty and exclusive benefit rules. In today’s polarized political world, ESG investments are especially controversial. There is a group in Congress that opposes them as “woke” and would be comfortable with prohibiting or strictly restricting them. Others who are equally vocal feel that responsible investing should take ESG into account.

When the Trump administration’s proposed regulations attempting to restrict ESG investments and discourage related proxy voting were open to public comment, the Department of Labor (DOL) received more than 8730 comments, 96% of which opposed the proposed regulations. The final regulations (the 2020 Version) did little to accommodate these negative comments, though they removed references to ESG and instead required fiduciaries to make investments based solely on “pecuniary factors.”

Prior DOL Guidance. Prior to the Trump Administration, the DOL issued IB 2015-01. IB 2015-01 did not allow fiduciaries to accept more risk or lower returns in order to pursue ESG investment programs, but allowed ESG investments to be selected as tie-breakers when ESG and non-ESG choices were comparable in return and risk over the appropriate time horizon. In the view of many who filed public comments, when the Trump Administration changed the rules, it put a thumb on the scale against ESG investing. It did this primarily by limiting the ability to use ESG as a tie-breaker to situations in which the investments were economically identical, which would be rare. The 2020 Version also prohibited selecting any investments whose offering material described any ESG-related principals or factors as qualified default investments (QDIAs) and imposed new recordkeeping requirements viewed by many as burdensome. In addition, regulations on proxy voting issued with the 2020 Version seemed to make it difficult to justify voting proxies in many situations, including in favor of ESG proposals.

New Regulations Are Less Rigid.  The Biden administration signaled early that it would not be enforcing  the prior ESG regulations, and recently issued final regulations (the 2022 Version) that reversed course and moved towards  a more neutral position on ESG investing. The 2022 Version does not require fiduciaries to take ESG considerations into account, but permits ESG investments consistent with ERISA’s fiduciary rules. The 2022 Version recognizes that fiduciary responsibilities may sometimes require ESG factors to be taken into account when evaluating plan investments. The 2022 Version also removes the restriction against using an investment that considers ESG factors as a QDIA, and eliminates safe harbors that were viewed by critics of the 2020 Version as deterring the voting of proxies by plan fiduciaries.

Both the 2020 Version  and the 2022 Version prohibit fiduciaries from accepting greater risk or lower returns in order to make ESG investments, but there are few other similarities. Here is a summary of the major changes made to the Trump-era regulations:

Permissibility– The 2020 Version was widely interpreted as having a chilling effect on ESG investment, though the final iteration referred more generically to a duty to make investments based on pecuniary factors. The Biden Administration’s proposed regulations originally stated that ESG factors often had to be taken into account by fiduciaries, but the 2022 Version as finalized stepped back from that approach to state that ESG factors may affect the value of plan investments and may be taken into account as collateral factors. Examples were deleted from the final regulations, but anyone can suggest situations where considering ESG factors might be important, such as evaluating investment in a company with exposure for creating environmental damage or a company whose revenue is adversely affected by poor governance. Still,  the 2022 Version does not contain any mandates that fiduciaries take ESG factors into account.  The 2022 Version seems to defer to a fiduciary’s individual judgment.

The Tie-Breaker Test. The 2022 Version no longer requires investments to be economically indistinguishable before ESG factors may be taken into account as tie-breakers. ESG and other “collateral benefits” may be a tie-breaking factor when alternative investments under consideration equally serve the financial interests of the plan. Stimulating union jobs is an example of another permissible collateral benefit. The 2022 Version also eliminates a special documentation requirement that applied in a tie-breaking situation and a requirement to make special disclosures to participants in defined contribution plans when the tie-breaker standard is used.

QDIAs.  The 2020 Version prohibited using a QDIA whose objectives or principal investment strategies included or indicated a use of non-financial factors. It appeared that any references to non-financial factors in offering material could make a fund, model portfolio or product unavailable as a QDIA. Under the 2022 Version, special restrictions have been eliminated and the QDIA selection process will be subject to general fiduciary standards.

Participant Preferences. The 2020 Version did not permit taking participant preferences into account even  when the plan had participant-directed investments. The 2022 Version permits a fiduciary of a plan with self-directed investments to consider participant preferences when constructing a menu of prudent investment options and states that simply taking participants’ nonfinancial preferences into account does not breach the duty of loyalty. Additional investment options may be added without necessarily using the tie-breaker standard, since “adding additional investment options is not necessarily a zero-sum game.”

Proxy Voting Changes.

DOL guidance on proxy voting issued prior to the 2020 Version (IB 2016-01) indicated that there is a fiduciary duty to vote proxies that resides with the trustee unless the trustee is subject to direction by a named fiduciary or an investment manager has been delegated authority to vote proxies. The plan sponsor or other company fiduciaries could reserve the right to vote proxies. The DOL indicated that proxies should be voted on issues that could affect the value of the plan’s investments, though it recognized that there could be situations where high costs outweighed the potential benefit. The 2020 Version said that proxies should be exercised in accordance with a plan’s economic interest, imposed special recordkeeping requirements relating to proxies and established two safe harbors with the effect of limiting the situations in which proxies had to be voted. Here are the principal changes made in Version 2:

·       The 2022 Version eliminates special monitoring obligations with respect to third parties authorized to vote proxies or when a third-party provides proxy voting advice.

·       The 2022 Version removes a statement that fiduciary duty does not require the voting of every proxy or the exercise of every shareholder right.

·       The 2022 Version eliminates two optional safe harbor proxy policies viewed as justifying not voting proxies. The first safe harbor limited proxy voting to situations in which the issue was substantially related to the issuer’s business activities or could have a material effect on the value of the plan’s investment. The second safe harbor allowed a plan to establish a policy that proxies would not be voted when the plan’s interest was so small that voting would not have a material impact on the plan’s investments.

·       The 2022 Version eliminates special recordkeeping requirements with respect to proxy voting.

·       Version 2 requires fiduciaries of pooled vehicles (such as collective trusts) to accommodate different proxy policies of investing plans by potentially voting the shares proportionately. This may be avoided if, for example, an investment manager has a standard proxy voting policy which all of the plans agree to adopt.

·       Version 2 requires a fiduciary to review a third party’s proxy voting guidelines for consistency with ERISA.

The cumulative impact of these changes is to put into place rules that are similar to the guidance in effect before the 2020 Version.

Effective Dates.  The 2022 becomes effective on January 30, 2023. There is, however, a delayed effective date of December 1, 2023 for the provisions requiring review of third-party proxy voting policies for consistency with ERISA and for investment managers of pooled vehicles. The second extension will allow those managers of pooled vehicles who want to have their plans adopt a uniform proxy voting policy time to implement such policies.

Looking to 2023 and Beyond.  While the flexibility in the 2022 Version is welcome, the political controversy over ESG investing shows no signs of abating. Some conservative states are moving against firms that do ESG investing, and there remains some possibility of federal legislation pushing the pendulum back. For example, Senator Mike Braun has introduced the Americans’ Retirement Security Act to reinstate the Trump rules legislatively. Plans with ESG investments may also have more litigation exposure as class action counsel may start to focus on whether returns have been sacrificed in selecting plan investment options. Yet ESG options will appeal to younger participants and may increase plan participation, and there are always going to be some situations in which ESG factors can have a significant economic impact on investments.

What is a fiduciary to do now? Fiduciaries who have already made ESG investments can breathe a sigh of relief, at least for now. A legislative rollback to the 2020 Version seems unlikely under the current administration, but the future prospects are unclear. ESG investments have recently been underperforming when compared to the broader market, perhaps increasing litigation exposure and complicating any decisions about new ESG investing. Prudent fiduciaries will proceed with caution and seek professional assistance when necessary to evaluate funds using ESG criteria. Despite the elimination of special recordkeeping requirements for both ESG investments and proxy voting, it is still advisable as a matter of good fiduciary practice to carefully document what was done in writing along with the reasons for any ESG-related decisions.





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