Fiduciaries and their advisors have long debated how much they can or should consider what are commonly called Environmental, Social and Governance (ESG) factors when making investment decisions. And since 1994, the U.S. Department of Labor (DOL) has offered shifting guidance on this important topic. On June 23, 2020, the DOL released proposed amendments to Employee Retirement Income Security Act (ERISA) regulations relating to ESG that some commentators say will chill sustainable investing practices. Are their concerns justified, and what are the takeaways for public pension plans?
Previous DOL Guidance
Some context is necessary to understand the DOL’s proposed regulations. In 1994, 2008 and again in 2015, the DOL issued Interpretive Bulletins that applied the fiduciary standards of ERISA to what were then called economically targeted investments (ETIs). Interpretive Bulletins are not legally binding on governmental plans, which are not covered by ERISA, but they nonetheless provide the most discrete and useful guidance for public plan fiduciaries considering ESG investing.
Interpretive Bulletin 94-1: The “All Things Being Equal Test”
Interpretive Bulletin 94-1 (IB 94-1), was published to “correct a popular misconception” that ETIs were wholly incompatible with ERISA’s fiduciary requirements. In IB 94-1, the DOL used baseline fiduciary principles under ERISA and common law—that plan investments must be prudently managed for the exclusive benefit of plan participants— to establish what came to be known as the “all things being equal test” for ETIs. This test expressly permitted the consideration of collateral benefits while reaffirming that the interests of plan participants remained paramount. Only where there was a “tie” between the economic aspects of two potential investments could the consideration of collateral benefits function as the “tie-breaker” and permit a plan fiduciary to select the ESG investment.
Interpretive Bulletin 08-1: All Things Are Rarely Equal
In 2008, the DOL issued Interpretive Bulletin 2008-01 (IB 08-01), which superseded IB 94-1 and expressed the Department’s perspective at that time that the situations in which collateral benefits may be used as a “tie-breaker” would be “very limited.” The bulletin’s language was overtly skeptical of ETIs and viewed the consideration of collateral benefits to be entirely distinguishable from a fund’s more traditional financial analysis of potential investments. IB 08-01 applied the “tie-breaker” rule from IB 94-1 limited by a belief that alternative investment options would rarely be economically equivalent. IB 08-01 directed plan fiduciaries to undertake “a quantitative and qualitative analysis of the economic impact on the plan” of competing investment alternatives before concluding that such alternatives were equal.
Interpretive Bulletin 15-1: Not Merely Collateral Considerations
The DOL tacked again in 2015, issuing Interpretative Bulletin 2015-01 (IB 15-01) out of a stated concern that IB 08-01 had “unduly discouraged” the consideration of ETIs and ESG factors. The DOL believed that the 2008 guidance could be dissuading fiduciaries from pursuing investment strategies that considered ESG factors where they were used solely to evaluate the economic benefits of investments, and investing in ESGs where economically equivalent. Accordingly, it withdrew IB 08- 01 and reinstated the language from IB 94-1. The language and tone of this bulletin differed markedly from the two previous ones and used the term “ESG” for the first time. Notably, the DOL did not restrict its characterization of historically “non-economic” factors to “collateral benefits,” but spoke in terms of ESG issues affecting the “economic merits” of investment analysis. The DOL acknowledged that ESG factors were not always collateral to economic analyses but might instead directly affect the economic value of the plan’s investments. In such instances, the DOL said, ESG factors were not mere tie-breakers but rather proper components of a fiduciary’s primary analysis of the economic merits of competing investment choices.
Back to the Future
The pendulum swung again in 2018 when the DOL issued a Field Assistance Bulletin (providing guidance to DOL staff to address questions arising under Interpretive Bulletins) that cautioned fiduciaries about too readily treating ESG factors as economically relevant. This, it turned out, was a precursor to the proposed regulations that the DOL issued for public comment in June.
2020 Proposed Regulations: All Things Are Almost Never Equal
Reflecting a return to the skepticism it articulated in 2008, the DOL states that “ESG investing raises heightened concerns under ERISA.” According to the DOL, the growing emphasis on ESG investing may be prompting fiduciaries to make investment decisions for purposes other than the only permissible reasons—providing benefits to participants and beneficiaries and defraying reasonable expenses of administering the plan.
The proposed regulations are intended to confirm that ERISA requires plan fiduciaries to select investments based solely on financial considerations relevant to the risk-adjusted economic value of a particular investment. They also make clear that fiduciaries may not invest in ESG vehicles when they understand an underlying investment strategy of the vehicle is to subordinate return or increase risk for the purpose of what the DOL refers to as non-pecuniary objectives.
While the DOL acknowledges that ESG factors may qualify as economic considerations, they caution that this is true “only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories.”
As to tie breakers under the “all things being equal” test, the DOL “expects that true ties rarely, if ever, occur.”
Commentators say the proposed regulations will chill ESG investing. They clearly reflect a return to skepticism, as shown by the DOL’s statement that ESG investing raises heightened concerns. It is also noteworthy that the DOL chose to issue the latest ESG guidance by regulation, rather than sub-regulatory guidance in the form of an Interpretive Bulletin or Field Assistance Bulletin; if adopted, such regulations would have the force and effect of law. Still, it is possible that these regulations, even if ultimately adopted as drafted, might not necessarily reflect a sea change for prudent fiduciaries.
- The underlying fiduciary principles remain unchanged: Fiduciaries have always been bound by the exclusive benefit rule and the duties of loyalty and prudence, which remain unchanged. For example, under the Internal Revenue Code, no part of the corpus or income of a pension trust (including a public pension trust) may be used for purposes other than the exclusive benefit of participants and beneficiaries.
- Prudent fiduciaries focus on the plan’s financial risks and returns, and keep the interests of plan participants and beneficiaries paramount: Prudent fiduciaries do not sacrifice investment returns, take on additional risk, or pay higher fees to promote non-pecuniary benefits or goals.
- ESG investing can fit within the framework under the proposed regulations: The DOL specifically recognizes that there may be instances where factors that are considered without regard to their pecuniary import, such as environmental considerations, will present an economic business risk or opportunity that would be appropriately treated as material economic considerations under generally accepted investment theories. The DOL gives examples, such as improper disposal of hazardous waste or dysfunctional corporate governance, that likely implicate business risks and opportunities, litigation exposure, and regulatory obligations.
- Document, document, document: As always, the key is documentation. Fiduciaries will demonstrate prudence through their documentation of the weight given to ESG factors in light of the assessment of their impact on risk and return; the economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories; the examination of the level of diversification, degree of liquidity, and potential risk-return in comparison with other available investments that could play a similar role in their plan’s portfolios. Finally, if using the “all things being equal” test, they will document specifically why the investments were determined to be indistinguishable and why the elected investment was chosen based on the purposes of the plan, diversifications of investments, and interest of the plan participants and beneficiaries in receiving benefits form the plan.
In the regulatory impact analysis, the DOL states that it believes most fiduciaries are operating in compliance with their guidance. The DOL’s concern instead seems to lie with the lack of consensus about what constitutes an ESG investment, certain investment products being marketed to ERISA fiduciaries, and vague and inconsistent ESG rating systems.
The proposed regulations may not necessarily represent the death knell for public pension plans that wish to incorporate consideration of ESG factors in their investing practices, provided they do so in a manner that reflects proper attention to their fiduciary duties.