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DOL Issues Final Rule on ESG Investing and Proxy Voting (Registered Funds Regulatory Update)

01.09.23

(Article from Registered Funds Regulatory Update, January 2023)

For more information, please visit the Registered Funds Resource Center.

The U.S. Department of Labor recently issued a final rule that seeks to clarify the circumstances under which a fiduciary subject to ERISA may consider climate change and other ESG factors when making investment decisions (and exercising shareholder rights) on behalf of ERISA plans and “plan asset” vehicles. Many fund sponsors structure their funds to avoid being deemed to hold “plan assets,” such as by relying on the “venture capital operating company” and “real estate operating company” exceptions or by satisfying the “25% test.” In those instances, ERISA is not applicable to the management of those funds and the general partner (and investment manager) of such fund need not comply with the final rule. Note that, while the final rule does not directly implicate the sponsor of a non-plan assets fund, the final rule may nonetheless affect its marketability to prospective ERISA plan limited partners. Moreover, governmental plans are not subject to ERISA; however, their governing laws may contain ERISA-like language and compliance therewith may be informed by DOL rules, such as the final rule. The final rule largely goes into effect on January 30, 2023.

At a high level, the final rule is not intended to encourage, much less mandate, a fiduciary’s consideration of ESG factors when making investment decisions (or exercising shareholder rights) related to investments held by a plan. Instead, the final rule clarifies the ways in which an ERISA fiduciary may consider ESG factors, and exercise shareholder rights related to plan investments, in a manner consistent with ERISA’s duties of prudence and loyalty.

Investment Risk/Return Factors. The final rule reaffirms the DOL’s longstanding position that a fiduciary should base its investment decisions on factors that the fiduciary reasonably determines are relevant to an investment’s risk and return. Moreover, fiduciaries may not sacrifice investment returns or take on additional investment risk to further objectives that are unrelated to the provision of retirement or other financial benefits under the plan.

Tie-Breaker Test. The final rule breathes new life into a fiduciary’s ability to use an ESG characteristic of an investment, which does not affect risk/return, as the decisive factor in selecting one investment over another, provided both investment opportunities “equally serve the financial interests of the plan over the appropriate time horizon.” This framework (known as the “tie-breaker” test) has long been available under DOL guidance. In 2020, however, the Financial Factors rule recast the tie-breaker test in such a way, and imposed such restrictions on its use, including a heighted documentation requirement, that some felt nullified the test itself. The final rule reinstates the tie-breaker test but disregards the additional documentation requirement, adding an additional tool for fiduciaries to consider ESG factors without violating ERISA’s fiduciary duties.

QDIAs. The final rule now provides that a plan fiduciary may select a “qualified default investment alternative” (“QDIA”), the default investment option on a 401(k) plan menu, under the same standard as any other investment option. This is a marked change from the Financial Factors rule, which provided that a fund could not be selected as a QDIA if it, or any of its component funds, had investment objectives, goals or principal investment strategies that included, considered, or indicated the use of non-pecuniary factors. 

Participant Preferences. The final rule clarifies that fiduciaries do not automatically violate ERISA’s duty of loyalty by taking plan participants’ preferences into account when constructing a 401(k) plan lineup. On the one hand, this aspect of the final rule may lead to greater incorporation of ESG funds in plan lineups. On the other hand, however, it remains to be seen how plan fiduciaries will actually ascertain the preferences of plan participants and whether the steps to gather that information may ultimately be an additional source of litigation risk. Lastly, it is imperative to note that fiduciaries remain duty-bound to prudently select investment options, such as by considering an investment option’s track record, fees, and expenses, etc., and this is an area that remains subject to relentless class action litigation.

ESG Factors as Investment Risk/Return Factors. The final rule reiterates the DOL’s historical position that fiduciaries can and should consider any and all factors that are relevant to the risk/return analysis. In this respect, both the final rule and the DOL’s prior authority over the past ten years, including the Financial Factors rule, all expressly acknowledge that ESG factors may, under certain circumstances, in fact affect an investment’s risk/return characteristics. This means that a fiduciary may consider the ESG factor alongside other relevant risk/return factors — without needing to satisfy the aforementioned tie-breaker test — if the fiduciary prudently determines that the factor is relevant to investment performance.

Shareholder Rights. The final rule clarifies that the voting of proxies, and the exercise of other shareholder rights, with respect to ERISA plan assets is fiduciary conduct under ERISA. Moreover, proxies should be voted unless a responsible plan fiduciary determines voting proxies are not in the plan’s best interest, such as where the costs to do so are exceptionally high. This means that the fiduciary, when exercising shareholder rights on behalf of a plan, must (i) act solely in accordance with the economic interests of the plan; (ii) consider any costs involved; (iii) not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits to any other objective; and (iv) evaluate relevant facts that form the basis for the proxy vote or other exercise of shareholder rights.

Proxy Advisory Firms. The final rule includes a general requirement that a fiduciary monitor proxy advisory firms, though it did not retain the more specific monitoring duties that were included in the Financial Factors rule. The DOL expects fiduciaries to assess the qualifications of the proxy advisors and the reasonableness of the fees for such services, as well as to be fully informed of potential conflicts of the proxy advisor and the steps such proxy advisor has taken to address them.

Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights, 87 FR 73822 (Dec. 1, 2022), available at: https://www.govinfo.gov/content/pkg/FR-2022-12-01/pdf/2022-25783.pdf.