DOL secures key dismissal in challenge to ESG rule

Environmental, social and governance investing has become a political battlefield in recent years, but in the latest salvo, a federal judge with a conservative record backed the Department of Labor in a lawsuit challenging its self-described "neutral" rule permitting retirement plan fiduciaries to consider ESG factors when selecting investments.

"It's nice to see that a Trump-appointed judge actually came down with legal precedence to rebuke, basically, what was a pretty broken argument being made by the plaintiffs," said Jeffrey Vilker, director of defined contribution at Impax Asset Management and proponent of the Labor Department rule.

In a Sept. 21 ruling, Judge Matthew J. Kacsmaryk said the commonly referred to "ESG rule" — officially the Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights rule — which took effect Jan. 30 and allows ERISA fiduciaries to consider ESG factors, does not violate the Employee Retirement Income Security Act, nor is it arbitrary and capricious.

In January, Republican attorneys general from 26 states filed a lawsuit — State of Utah et al. v. Su et al. — in U.S. District Court in Amarillo, Texas, arguing that the Labor Department's rule undermines key protections for retirement savers, oversteps the department's authority under ERISA and is arbitrary and capricious.

But in his decision, Kacsmaryk disagreed.

"The 2022 rule 'provides that where a fiduciary reasonably determines that an investment strategy will maximize risk-adjusted returns, a fiduciary may pursue the strategy, whether pro-ESG, anti-ESG, or entirely unrelated to ESG,'" he wrote, citing an April amicus brief filed in support of the Labor Department by retirement expert J. Mark Iwry. "And like prior rules, the 2022 rule allows consideration of collateral factors to break a tie. Thus … the court cannot conclude that the rule is 'manifestly contrary to the statute.'"

Prior legal precedent cited by Kacsmaryk states that to avoid violating the Administrative Procedures Act, all that is necessary is a minimal level of analysis from which the agency's reasoning can be discerned. The Labor Department provided that in this case, Kacsmaryk said.

"The department is pleased with the judge's decision upholding its rule as consistent with ERISA and the Administrative Procedures Act," a Labor Department spokesman said in an email when asked for comment.

In February, the department filed a motion to move the case to Washington and accused the plaintiffs of "forum shopping" to get Kacsmaryk to hear the case. Kacsmaryk in March denied that motion and the case proceeded.

In a statement to Pensions & Investments, Utah Attorney General Sean Reyes said he and his co-plaintiffs are disappointed by the judge's decision and may pursue additional legal avenues. "We are evaluating next steps, including potential appeal," he said. "We will continue to fight on all fronts to protect the interests of investors and all Utahns against the ESG agenda."

The Labor Department rule, which officials often describe as neutral, maintains the department's position that fiduciaries may not sacrifice investment returns or assume greater investment risks as a means of promoting collateral social policy goals.

The 2022 rule came after a rule promulgated late in the Trump administration that said retirement plan fiduciaries could not invest in "non-pecuniary" vehicles that sacrifice investment returns or take on additional risk.

"Substantively, the current rule and the Trump administration rule are essentially the same," Iwry said in the amicus brief and again in an interview. Iwry, a former senior adviser to the secretary of the Treasury and deputy assistant secretary for retirement and health policy and currently a visiting scholar at University of Pennsylvania's The Wharton School and non-resident senior fellow at the Brookings Institution, wrote the brief with Covington & Burling LLP, which served as legal counsel.

"We felt it was important to support the court in taking a clear-eyed view of the law, which it did, successfully avoiding the political, hyper-partisanship around this issue," Iwry said.

If the plaintiffs appeal the rule, they could argue that Kacsmaryk was too deferential to the Labor Department in reaching his decision, said Kevin L. Walsh, a principal with Groom Law Group. "In the analysis the judge here pretty heavily relied on the idea of Chevron deference in ruling in the agency's favor," Walsh said, referencing a legal precedent where a federal judge defers to an agency's interpretation of a given statute. "In the past decade courts have increasingly called into question whether Chevron deference is the appropriate amount of letting an agency sub its judgment in for the judge's judgment. If this were to be appealed, I wouldn't be surprised that one of the things that the state attorneys general argue is that this judge was too deferential."

Of note, the U.S. Supreme Court will hear a case this term challenging the Chevron deference precedent.

But for now, the ruling in Texas could help the Labor Department fend off another legal challenge to the rule in Wisconsin, according to Walsh. "Any time you get a decision in your favor, it provides additional persuasive precedence with the next judge," he said. "If you win on issues it can sometimes build on itself."

Two 401(k) plan participants filed a similar lawsuit in February in U.S. District Court in Milwaukee that alleges the Labor Department exceeded its authority in issuing the rule.

The day after the ruling in Texas, the Department of Justice, which represents the Labor Department in legal disputes, filed a notice of supplemental authority in Milwaukee, alerting the judge in the second case of Kacsmaryk's ruling.

The Labor Department's current rule and track record on the issue should provide plan fiduciaries a sufficient framework to manage their responsibilities under ERISA when considering one or more ESG factors in an investment decision, said George M. Gerstein, senior counsel in Simpson Thacher & Bartlett's executive compensation and employee benefits practice. "With that said, I think ERISA fiduciaries should recognize that there is perhaps a heightened litigation risk, at least in the short- to medium-term, when ESG-related factors are being incorporated, and, therefore, be prepared to defend the decision-making process as being one of cool-headed prudence."

As ESG has become a political flashpoint, retirement plans have seen increased legal challenges, notably American Airlines. In June, an American Airlines pilot sued the company and its fiduciaries in a U.S. District Court in Fort Worth, Texas, alleging that two company 401(k) plans violate ERISA by offering investments that emphasize ESG principles.

Vilker said he expects other ESG legal challenges to fall short in court. "The cases I have seen being brought" — the American Airlines case included — "to me, appear to be pure political rhetoric with little to no legal precedent to support them," he said. "So I do believe you'll see a continuation of what was started in (the Texas) ruling: legal precedents and not politics."