Ned Hedley
Last week, the plaintiffs in Utah v. Walsh, filed a motion seeking to enjoin the implementation of the Department of Labor’s (DOL) new regulation that makes it easier for retirement plan fiduciaries to consider environmental, social, or governance (ESG) factors when making investment decisions or exercising shareholder rights tied to plan assets. The plaintiffs—a coalition comprised of 26 states and a handful of private plaintiffs including individuals, oil-and-gas companies, and a trade association—assert that the new ESG Rule subverts the protections in the Employee Retirement Income Security Act of 1974 (ERISA) because it permits plan fiduciaries to stray from the exclusive purpose of acting in the financial best interests of plan participants and beneficiaries.
The ESG Rule replaces two regulations promulgated by the Trump administration that reinforced the ERISA statute’s requirement that fiduciaries focus exclusively on pecuniary factors when making investment decisions and exercising shareholder rights. DOL cited two Biden executive orders related to climate change as the reason for the new rule.
The ESG Rule formally injects ESG factors into investment and shareholder rights decisions. It also permits plan fiduciaries to consider participant preferences when selecting investment options for self-directed defined contribution plans like a typical 401(k) plan. The rule removes limitations on plan investment options such that an ESG fund may now be included as a Qualified Default Investment Alternative (QDIA). Hence, fiduciaries are now permitted to select funds that expressly prioritize non-financial benefits, like ESG factors, as the default investment for plan participants.
Compounding this problem, the new rule eliminates certain recordkeeping and disclosure requirements as to when fiduciaries use collateral ESG factors in making investment decisions or exercising shareholder rights. This change deprives plan participants and beneficiaries of crucial information by which to judge whether fiduciaries are acting in their best interest. Fiduciaries thus can consider ESG factors without necessarily disclosing when and which factors the fiduciary relied upon when making an investment decision or exercising shareholder rights. Without this measure of accountability, plan participants can only speculate whether fiduciaries or their agents are substituting their own ESG policy preferences rather than acting exclusively in the best financial interests of plan participants.
The plaintiffs challenging the ESG Rule argue that it is contrary to the ERISA statute, exceeds the DOL’s authority, and is arbitrary and capricious. They point out, in line with Professors Max Schanzenbach and Robert Sitkoff, that “ERISA codifies the trust law sole interest rule by mandating that a pension trustee act solely in the interest of participants and beneficiaries” and for the “exclusive purpose” of “providing benefits” to them. In Fifth Third Bancorp v. Dudenhoeffer, the Supreme Court emphasized that the underlying aim of the sole interest or exclusive benefit rule is to protect participants’ “financial benefits.” Dudenhoeffer involved an allegation of breach of the exclusive benefit rule over management of an Employee Stock Ownership Plan (ESOP), a retirement investment vehicle that by its nature incorporates a collateral interest, promoting employee ownership of a corporation. The Court nonetheless found that ERISA’s duties of loyalty and prudence mandate that, even in the context of an ESOP, fiduciaries must adhere to the exclusive benefit standard; and that a pension trustee breaches the duty of loyalty and prudence if the trustee acts other than to financially benefit the participants or beneficiaries, including failing to reduce the ESOPs exposure to the sponsor company stock.
Congress recognized the importance of a secure financial retirement when it found “that the continued well-being and security of millions of employees and their dependents are directly affected by these plans; that they are affected with a national public interest.” It also recognized the need for heightened standards for fiduciaries and greater transparency. As the Seventh Circuit said, “ERISA was enacted by Congress in 1974 after determining that the then present system of regulation was ineffective in monitoring and preventing fraud and other pension fund abuses.” Consequently, ERISA imposes strict, uniform standards upon retirement plan fiduciaries along with robust disclosure and transparency requirements such that plan fiduciaries are kept on a tight leash and plan participants are not at a disadvantage in policing fiduciaries who stray from ERISA’s rigid standards.
Instead of advancing the aims of Congress in passing ERISA, the new rule loosens the strict limitations on fiduciaries and reduces transparency and accountability. It invites ERISA fiduciaries, investment advisors, and asset managers to wade into complex and sometimes conflicting public policy matters and make investment decisions that may reflect their ESG policy preferences rather than focusing on what is in the best pecuniary or financial interests of the more than 150 million American workers who are ERISA plan participants and beneficiaries. That was not Congress’s intent when it passed ERISA and set out the exclusive benefit rule in the text of the statute. Indeed, Congress rejected several ERISA provisions that would have encouraged socially desirable or socially responsible investing.
The 2020 rules adhered to the strict limitations of ERISA, requiring fiduciaries to focus on whether an investment decision or exercise of shareholder rights will achieve the best risk-adjusted returns for pension plan participants. The ESG Rule deviates from this objective standard, in part because it fails to define or even provide guidance on what constitutes an ESG factor. Consequently, the new rule permits fiduciaries a degree of latitude to consider ESG factors and perhaps substitute their own ESG policy preferences, rather than adhering to the narrow confines and more objective financial or pecuniary benefit standard of the exclusive benefit rule.
The problems with using ESG factors in investment or shareholder rights decisions is illustrated by studies that show that ESG investing has poor outcomes. The Wall Street Journal reported in 2021 that a study of exchange traded funds (ETFs) that have an ESG focus have 43 percent higher fees than other ETFs. The study by the Pacific Research Institute revealed that, over a ten-year period, $10,000 invested in an ESG fund would be about 44% lower than an investment in a fund or ETF that tracks the S&P 500 stock index. Furthermore, the former head of sustainable investing at Blackrock, one of the world’s largest asset managers, has stated that “the ESG industry today consists of products that have higher fees but little to no impact and narratives that mislead the public.”
Utah v. Walsh also presents separation of powers questions. For instance, DOL justified the removal of limits on QDIAs because it thought that permitting fiduciaries to consider participant preferences would lead to increased participation and employee contribution rates to retirement plans, particularly among younger workers. But such a move is contrary to Congress’s intent when it passed ERISA and incorporated strict duties of loyalty and prudence. Congress considered and rejected several proposals that would have allowed fiduciaries to consider collateral factors. One collateral factor that Congress did allow was ESOPs, but even then, as Dudenhoeffer made clear, the rigid statutory duties of loyalty and prudence trump the statutorily permitted collateral consideration of employee stock ownership. Hence, if DOL or others believe that participant preferences for ESG funds will increase plan participation and employee contributions, they are free to petition Congress to amend ERISA. What DOL cannot do is defy ERISA’s duties of loyalty and prudence and permit fiduciaries to consider participant preferences as a justification for including ESG funds in retirement plans.
The multitude of potentially conflicting ESG factors, preferences, and policy priorities are better addressed by Congress. The new rule will have the practical effect of outsourcing potentially significant ESG policy decisions to a comparatively small number of plan fiduciaries, asset managers, and investment advisors responsible for pension investment decisions or for exercising shareholder proxy rights. Many of these ESG issues are matters that are better left to the legislative process, rather than in the hands of a small group of investment advisors and asset managers who manage vast sums of pension money.
It is noteworthy that the week after plaintiffs filed their motion seeking a preliminary injunction, Congress weighed in using the Congressional Review Act to rescind the new rule. This is something Congress declined to do with respect to the 2020 rules despite the current administration’s party holding majorities in both chambers.
Stay tuned for additional developments in this case.