Introduction

On November 22, 2022, the Department of Labor (“DOL”) released a final rule — Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights (“Final Rule”) — under the Employee Retirement Income Security Act of 1974 (ERISA) that “clarif[ied] that fiduciaries may consider climate change and other environmental, social, and governance (ESG) factors when they make investment decisions and when they exercise shareholder rights, including voting on shareholder resolutions and board nominations.”^[1] This final rule effectively overturned two rules published in the last months of the Trump administration, which essentially prohibited the consideration of ESG factors when ERISA fiduciaries selected investments or exercised shareholder rights. In effect, the Biden administration has now enabled fiduciaries managing ERISA funds to consider “factors [that] may include the economic effects of climate change and other ESG considerations on the particular investment or investment course of action.”^[2]

Background: ESG Initiatives & the Biden Administration

This action by the DOL is merely the latest of several initiatives undertaken by the Biden administration to enable (and promote) consideration of ESG factors, particularly climate-related risks, in the context of financial decision-making. Indeed, on May 20, 2021, President Biden issued Executive Order 14030 on “Climate-Related Financial Risk,” announcing that it is “the policy of my Administration to advance consistent, clear, intelligible, comparable, and accurate disclosure of climate-related risk.”^[3]

Since that time, the Biden administration has developed several initiatives related to finance and climate-related risk, which include:

• A proposal by the Securities and Exchange Commission (“SEC”) that would “require registrants to include certain climate-related disclosures in their registration statements and periodic reports, including information about climate-related risks that are reasonably likely to have a material impact on their business, results of operations, or financial condition, and certain climate-related financial statement metrics . . . [and] disclosure of a registrant’s greenhouse gas emissions.”^[4]

• Proposing “the Federal Supplier Climate Risks and Resilience Rule, which would require major Federal contractors to publicly disclose their greenhouse gas emissions and climate-related financial risks and set science-based emissions reduction targets.”^[5]

• The establishment of the Climate Risk Unit at the Commodity Futures Trading Commission (“CFTC”)^[6] and the CFTC’s subsequent request for “public comment on climate-related financial risk to better inform its understanding and oversight of climate-related financial risk as pertinent to the derivatives markets and underlying commodities markets.”^[7]

Notably, Section 4 of Executive Order 14030 directed the Secretary of Labor to, among other things, “identify agency actions that can be taken under the Employee Retirement Income Security Act of 1974 (Public Law 93-406) . . . to protect the life savings and pensions of United States workers and families from the threats of climate-related financial risk,” and to “consider publishing . . . a proposed rule to suspend, revise, or rescind ‘Financial Factors in Selecting Plan Investments,’ 85 Fed. Reg. 72846 (November 13, 2020), and ‘Fiduciary Duties Regarding Proxy Voting and Shareholder Rights,’ 85 Fed. Re. 81658 (December 16, 2020).” This latest rule by the Secretary of Labor represents the culmination of this directive.

History of the Final Rule

The extent to which collateral considerations, including non-pecuniary factors, can influence the selection of ERISA investments has a long and convoluted history. The regulation in question — the Final Rule, which amends the Investment Duties regulation (Labor Regulation Section 2550.404a-1) under Title I of the Employee Retirement Income Security Act of 1974, as amended (ERISA) (the “Final Rule”) — has been the subject of substantial interpretive guidance and amendment over the last thirty years. Certain highlights of this history are summarized below.

First, in 1994, Interpretive Bulletin 94-1 (IB 94-1) addressed economically targeted investments (ETIs) selected, in part, for collateral benefits apart from the investment return to the plan investor. This guidance articulated the DOL’s so-called “all things being equal” or “tie-breaker” view: that ETIs are not inherently incompatible with ERISA’s fiduciary obligations if (i) the investment has an expected rate of return at least commensurate to rates of return of available alternative investments and (ii) the ETI is otherwise an appropriate investment for the plan in terms of such factors as diversification and the investment policy of the plan. Under these circumstances — when competing investments serve the plan’s economic interests equally well — plan fiduciaries can use such collateral considerations as the deciding factor for an investment decision.

This interpretive bulletin was later replaced in 2008 by Interpretive Bulletin 2008-01 (IB 2008-01) and, subsequently, in 2015 by Interpretive Bulletin 2015-01 (IB 2015-01). Although these interpretive bulletins differed from one another in some respects, each endorsed the “all things being equal” test and stressed that the paramount focus of plan fiduciaries must be the plan’s financial returns and providing promised benefits to participants and beneficiaries. Each Interpretive Bulletin cautioned that fiduciaries violate ERISA if they accept reduced expected returns or greater risks to secure social, environmental, or other policy goals.

Subsequently, in 2018, the DOL indicated in Field Assistance Bulletin 2018-01 (FAB 2018-01) that IB 2015-01 had recognized that there could be instances where ESG issues present material business risk or opportunities to companies that company officers and directors need to manage as part of the company’s business plan, and so that qualified investment professionals would treat the issues as material economic considerations under generally accepted investment theories. Thus, in these instances, the factors are not “tie-breakers,” but “risk-return” factors affecting the economic merits of the investment. Still, FAB 2018-01 further explained that while a prudently selected ESG investment could be added as an option to a 401(k) plan investment lineup from which plan participants select investments, the selection of an ESG-themed target date fund as a QDIA would not be prudent if the fund would provide a lower expected rate of return than available non-ESG alternative target date funds with commensurate degrees of risk, or if the fund would be riskier than non-ESG alternative available target date funds with commensurate rates of return.

A similar set of guidelines, reflecting a parallel timeline of policymaking, informed the guidance issued by the DOL concerning proxy voting and similar shareholder activities. The first Interpretive Bulletin (IB 94-2) on proxy voting was issued in 1994, and the subsequent interpretive bulletins were issued in 2008 (IB 2008-02) and 2016 (IB 2016-01), respectively. The ultimate thrust of IB 2016-01 was that in voting proxies, “the responsible fiduciary [must] consider those factors that may affect the value of the plan’s investment and not subordinate the interests of the participants and beneficiaries in their retirement income to unrelated objectives.”

In late 2020, the DOL published two final rules (the current regulation) pertaining to the selection of plan investments and the exercise of shareholder rights, ostensibly to address concerns that some investment products may be marketed to ERISA fiduciaries on the basis of purported benefits and goals unrelated to financial performance. Specifically, on November 13, 2020, the DOL published a final rule titled “Financial Factors in Selecting Plan Investments,”which adopted amendments to the Investment Duties regulation that generally require plan fiduciaries to select investments and investment courses of action based solely on consideration of “pecuniary factors.” Among these amendments was a prohibition against adding or retaining any investment fund, product, or model portfolio as a qualified default investment alternative (“QDIA”) if the fund, product, or model portfolio includes even one non-pecuniary objective in its investment objectives or principal investment strategies. Similarly, on December 16, 2020, the DOL published a final rule titled “Fiduciary Duties Regarding Proxy Voting and Shareholder Rights,” which also adopted amendments to the Investment Duties regulation to establish regulatory standards for the obligations of plan fiduciaries under ERISA when voting proxies and exercising other shareholder rights in connection with plan investments in shares of stock.

Following the publication of the current regulation, the DOL noted, however, that it may have created further uncertainty and engendered the undesirable effect of discouraging ERISA fiduciaries’ consideration of financially relevant ESG factors in investment decisions (such as climate change), even when it is in the financial interest of plans to take such considerations into account. (Notably, the DOL indicated that other investors in the marketplace had considered the potential financial risks and impacts associated with climate change and other ESG factors when enhancing investment value and performance or improving investment portfolio resilience.) On March 10, 2021, the Biden administration’s DOL announced a non-enforcement policy of the 2020 regulation.

Amendment to the Investment Duties Regulation Under ERISA: Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights

On November 22, 2022, the DOL issued the Final Rule. The Final Rule seeks to resolve confusion surrounding the application of ERISA’s fiduciary standards to the selection of certain investments, such as those that take into account environmental, social, or governance (ESG) considerations by clarifying the application of ERISA’s fiduciary duties of prudence and loyalty under Section 404(a) of ERISA to selecting investments and investment courses of action, including selecting QDIAs, exercising shareholder rights (such as proxy voting) and the use of written proxy voting policies and guidelines. The Final Rule is intended to alleviate uncertainty among ERISA plan fiduciaries regarding their ability to prudently select ESG investments or exercise certain shareholder rights without breaching their fiduciary responsibilities. The DOL’s longstanding position that ERISA fiduciaries, in selecting plan investments, may not sacrifice investment returns or assume greater investment risks as a means of promoting collateral social policy goals, coupled with the 2020 changes to the Investment Duties regulation, created, according to the DOL, a chilling effect and other potential negative consequences. Thus, the Final Rule reverses and modifies certain amendments that were made to the Investment Duties regulation in 2020.

Specifically, the Final Rule amends the Investment Duties regulation in several significant ways:

• Stating that a fiduciary’s determination with respect to an investment based on risk and return factors “may include the economic effects of climate change and other environmental, social, or governance factors on the particular investment or investment course of action.”

• “Removing the ‘based only on pecuniary factors’ language (and related terminology throughout) from the current regulation . . . [to] re-establish the Department’s position . . . that climate change and other ESG factors that may be relevant in a risk-return analysis of an investment do not need to be treated differently than other relevant investment factors,” including with respect to proxy voting and the exercise of shareholder rights.

• Incorporating a more flexible version of the tie-breaker concept under Section 2550.404a-1(c)(2) so that ESG factors (and other collateral benefits) may be considered when competing alternative investments “equally serve” the financial interests of the plan, rather than the more stringent “economically indistinguishable” standard in the 2020 regulation.

• Clarifying that a “plan fiduciary . . . does not violate the duty of loyalty . . . solely because the fiduciary takes into account participants’ preferences” when selecting prudent investments.

• Eliminating the prohibition on designating an investment as a QDIA “if it . . . has investment objectives, goals, or principal investment strategies that include, consider, or indicate the use of one or more non-pecuniary factors in its investment objectives,” echoing the same standards to selection criteria for investments generally.

• Encouraging more active use of proxy voting by eliminating two “‘safe harbor’ policies . . . [that the DOL] was concerned . . . could be construed as regulatory permission for plans to broadly abstain from proxy voting without properly considering their interests as shareholders” and by “eliminat[ing] the recordkeeping requirement . . . [with respect to] proxy voting activities and other exercises of shareholder rights.”

Overall, these changes are anticipated to change plan fiduciary investment behavior by encouraging more plan fiduciaries to utilize ESG factors when selecting investments. The Final Rule will enter into effect sixty (60) days after it is published in the Federal Register (and one year after publication for rules related to a fiduciary practice to follow the recommendations of a proxy advisory firm or other service provider, and related to investment and proxy voting policies of pooled funds).

Impact of the Final Rule

While it is impossible to predict the ultimate impact of this amendment on the governing ERISA regulations, the goal of this regulation and its desired effect is clear: to increase the salience of ESG factors when ERISA fiduciaries select investments. The second-order impact is also apparent: to encourage those managing investments in which ERISA fiduciaries may invest to provide information concerning ESG factors and (presumably) to act in conformity with the concomitant ESG principles. And, for investment managers to provide such information, the various recipients of funds — i.e., much of corporate America — will need to generate ESG data to satisfy those needs. Indeed, the mere fact that ESG data will be measured may encourage corporate actors to adjust their behavior to improve compliance — which can be reflected in ESG ratings and similar metrics, which in turn can drive investment activity. In essence, even if the amendment to the ERISA regulations itself is modest, the cascading effect on the investment community will be significant.

Notably, this action by the Biden administration stands in direct contrast to several state-level regulatory initiatives, which have sought (albeit with certain exceptions) to preclude the consideration of ESG factors by relevant state pension funds (which are not governed by ERISA). For example, Florida Governor DeSantis has “direct[ed] the state of Florida’s fund managers to invest state funds in a manner that prioritizes the highest return on investment for Florida’s taxpayers and retirees without considering the ideological agenda of the environmental, social, and corporate governance (ESG) movement . . . . ESG considerations will not be included in the state of Florida’s pension investment management practices.”^[8] A number of conservative-led states have adopted similar rules.

Although there is not yet a direct clash between these competing federal and state regulatory directives, it is likely that these competing policy priorities will be reflected not only in the political arena, but with respect to legal and corporate affairs as well.

Conclusion

This action by the Biden administration’s DOL to enable ERISA fiduciaries to consider ESG factors when selecting investments — and reversing the Trump administration’s efforts to preclude consideration of such factors — should be viewed in the broader context of the Biden administration’s efforts to promote ESG factors and disclosures with respect to financial decision-making. While the overall impact of this amendment to ERISA itself may be modest, as few ERISA investments may ultimately be driven by a consideration of ESG factors, the amendments act to increase the pressure on corporate America to provide relevant ESG information to investors — and thus to generate such data in the first instance. In effect, this regulatory rulemaking is simply one piece of a greater mosaic of initiatives designed to achieve the Biden administration’s desired result: a more prominent role for ESG issues, especially climate change, with respect to financial decision-making.

FOOTNOTES

^[1] Press Release, DOL, Final Rule on Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights (Nov. 22, 2022), https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/fact-sheets/final-rule-on-prudence-and-loyalty-in-selecting-plan-investments-and-exercising-shareholder-rights.

^[2] Id.

^[3] Exec. Order No. 14030, 86 FR 27967, Climate-Related Financial Risk (May 20, 2021), https://www.federalregister.gov/documents/2021/05/25/2021-11168/climate-related-financial-risk.

^[4] Press Release, SEC, SEC Proposes Rules to Enhance and Standardize Climate-Related Disclosures for Investors (Mar. 21, 2022), https://www.sec.gov/news/press-release/2022-46.

^[5] White House, Fact Sheet: Biden-Harris Administration Proposes Plan to Protect Federal Supply Chain from Climate-Related Risks (Nov. 10, 2022), https://www.whitehouse.gov/briefing-room/statements-releases/2022/11/10/fact-sheet-biden-harris-administration-proposes-plan-to-protect-federal-supply-chain-from-climate-related-risks/.

^[6] Press Release, CFTC, CFTC Acting Chairman Behnam Establishes New Climate Risk Unit (Mar. 17, 2021), https://www.cftc.gov/PressRoom/PressReleases/8368-21.

^[7] Press Release, CFTC, CFTC Releases Request for Information on Climate-Related Financial Risk (June 2, 2022), https://www.cftc.gov/PressRoom/PressReleases/8541-22.

^[8] Press Release, Governor Ron DeSantis Eliminates ESG Considerations from State Pension Investments (Aug. 23, 2022), https://www.flgov.com/2022/08/23/governor-ron-desantis-eliminates-esg-considerations-from-state-pension-investments/.