The DOL’s Latest ESG and Proxy Voting Proposals

The Department of Labor recently issued another set of proposed regulations seeking to address the perceived “artificial impediments” imposed by its two sets of final regulations finalized in late 2020. The proposed regulations, entitled “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” would negate the recently finalized regulations known as Financial Factors in Selecting Plan Investments (which addresses environmental, social, and governance investing), and the Fiduciary Duties Regarding Proxy Voting and Shareholder Rights.

In March, the DOL announced a nonenforcement policy regarding the ESG rules and the Proxy Voting rules. The Proposed Regulations are the result of the DOL’s conclusion that the ESG rules and Proxy Voting rules “may have inadvertently caused more confusion than clarity” and may actually “lead to less retirement security, because fiduciaries would feel like they needed to stay on the sidelines.”

PROPOSED REGULATIONS

The Proposed Regulations essentially restore the investment duty regulation for fiduciaries to its status prior to the new rules in 2020. Importantly, the Proposed Regulations reaffirm two long standing principles for investment fiduciaries:

1. A fiduciary may not subordinate the interest of the participants and beneficiaries in their retirement benefits under the plan to other objectives and may not sacrifice investment return or take on additional investment risk to promote benefits or goals unrelated to interests of the participants and beneficiaries in their retirement benefits.
2. The fiduciary duty of managing plan assets that are stock includes the management of shareholder rights related to the shares, including the right to vote proxies.

From these two central principles, the Proposed Regulations proceed to extend latitude to plan fiduciaries to assess investment options, including those that may have an ESG component, within ERISA’s rigorous fiduciary prudence and ‑loyalty standards based on the relevant facts and circumstances.

ESG Investments

Unlike the ESG rules finalized in 2020, the DOL Proposed Regulations give plan fiduciaries leeway to consider ESG factors, even suggesting that it may be a fiduciary’s duty to consider environmental and social components. Reports indicating that most ESG-oriented investment funds beat out the S&P 500 in early 2021^[1] back up the DOL’s concern that the impact of the existing ESG rules “would functionally lead to worse financial outcomes.” As a result, the Proposed Regulations make a wide range of changes to the ESG rules.

Primacy of Economic Returns

The DOL reiterated the longstanding principle that the fiduciary’s primary goal is the economic returns to maximize participants’ retirement benefits. The Proposed Regulations eliminate reference to “pecuniary factors” in the existing ESG rules and state that when evaluating an investment, a prudent fiduciary may consider any factor that, based on the facts and circumstances, is “material to the risk-return analysis.” The Proposed Regulations provide three examples of factors that, depending on the facts and circumstances, may be material to the risk–return analysis:

1. Climate change–related factors, such as a corporation’s exposure to the real and potential economic effects of climate change, including exposure to the physical and transitional risk of climate change and the positive or negative effect of government regulations and policies.
2. Governance factors, such as board composition, executive compensation, transparency and accountability in decision making, avoidance of criminal liability, and compliance with applicable laws.
3. Workforce practices, including the corporation’s progress on diversity and inclusion, labor relations, and investment in its workforce training.

Therefore, fiduciaries are encouraged to consider ESG factors, as long as ESG factors are viewed through an economic lens. 

Reinstate the Tiebreaker Rule and Shorten the Disclosure Requirements

The Proposed Regulations soften the language surrounding the situations when a fiduciary may consider non-economic “collateral benefits” when selecting an investment.  Under the existing ESG rules, non-pecuniary factors could only be considered if investments are “indistinguishable,” a narrow standard. In contrast, the Proposed Regulations provide that if two or more investments differ as to numerous attributes but, when considered in their totality, “equally serve the financial interests of the plan,” collateral factors may be considered to break the tie. ESG factors may be collateral factors.    

 The proposal also seeks to shorten the disclosure that a fiduciary is required to make upon invoking the tiebreaker analysis. Under the existing ESG rules, fiduciaries who use nonpecuniary factors when choosing between investments must prove why pecuniary factors were not enough to make such an investment decision. In the Proposed Regulations, the DOL’s “reconsidered view is that ERISA general prudence obligation is sufficiently protective in this context.”  

Investment Alternatives and QDIA Consideration of ESG Factors

 The Proposed Regulations also expand the use of collateral benefits and ESG factors to select investment alternatives, including a qualified default investment alternative (“QDIA”), for participant-directed defined contribution plans. The current ESG rules prohibit adding or retaining an investment fund, product, or model portfolio as a QDIA if the fund utilizes non-pecuniary investment strategies. The Proposed Regulations provide that collateral benefits and ESG factors may be used, provided that the characteristics of the collateral benefits are “prominently” disclosed to participants who are directing their investments.   

Proxy Voting     

The Proposed Regulations also amend the investment duty regulation in a manner consistent with the DOL’s guidance prior to the 2020 Proxy Voting rules. These changes will greatly reduce the documentation requirements required for fiduciaries choosing to vote proxies for a plan.

Duty to Vote

The Proposed Regulations remove the explicit statement that the fiduciary duty rules do not require the fiduciary to exercise every shareholder right, including voting every proxy. At the same time, the DOL explained in its preamble to the regulations that by removing the sentence from the regulations, it did not mean to imply that every proxy must be voted but that the presumption is that it will be unless the fiduciary determines that the cost of voting outweighs the benefits.

Eliminate Monitoring Obligation

The Proposed Regulations remove the fiduciary’s specific obligation to monitor any third-party proxy voting service to whom voting has been delegated. The DOL reasoned that ERISA’s fiduciary duties already require fiduciaries to monitor delegees, so proxy voting does not require special rules.

Removal of “Safe Harbors”

The Proxy Voting rules provide “safe harbors” that could be used to limit fiduciaries’ obligation to cast a proxy vote. In the Proposed Regulations, the DOL eliminates two of the safe harbors and requests comments on the benefits of safe harbors as a whole. The DOL reasoned that the safe harbors were not particularly helpful to protect plan participants and interfered with the facts and circumstances analysis of the fiduciary’s duties under ERISA.

Proxy Voting Records

The Proposed Regulations eliminate the requirement that plan fiduciaries maintain detailed records on proxy voting and all other exercises of shareholder rights. The DOL stated in the preamble to the Proposed Regulations that the exercise of these rights is no different than other fiduciary duties, so the general ERISA framework is sufficient to govern the proxy voting recordkeeping requirements.

TAKE AWAYS

If enacted, the Proposed Regulations will essentially return ERISA fiduciary duties with respect to ESG matters and the voting of proxies to the core principles of the fiduciary duties of prudence and loyalty. The proposed changes to the ESG rules and Proxy Voting rules removed perceived obstacles to consideration of ESG factors in investing and, in fact, require consideration of how ESG factors relate to the risk-return results of the particular investment. The DOL is accepting comments on the Proposed Regulations until December 13, 2021.

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_{[1] Esther Whieldon & Robert Clark, Most ESG funds outperformed S&P 500 in early 2021 as studies debate why, S&P Global Market Intelligence, https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/most-esg-funds-outperformed-s-p-500-in-early-2021-as-studies-debate-why-64811634.}