DOL ESG investing rule could be here to stay

Democrats and Republicans in Washington broadly view retirement plan fiduciaries considering ESG factors in investment decisions much differently, with the Trump and Biden administrations promulgating vastly dissimilar regulations on the issue.

A new rule proposal from the Department of Labor, which marks the latest move in a long-lasting regulatory fight, would explicitly permit retirement plan fiduciaries to consider climate change and other environmental, social and governance factors when selecting investments and exercising shareholder rights.

The proposal, which was unveiled Oct. 13 and has a 60-day comment period that concludes Dec. 13, is starkly different from two rules finalized in 2020 during the Trump administration. The proposal should give plan fiduciaries more comfort in integrating ESG factors into their plan lineups, sources said.

"I think this will quite clearly accelerate the incorporation of ESG factors into investment decision-making by ERISA fiduciaries," said George Michael Gerstein, co-chairman of the fiduciary governance and ESG groups at Stradley Ronon Stevens & Young LLP in Washington. "The rule will give plan sponsors enough cover, so they'll feel confident incorporating ESG factors."

Mr. Gerstein added: "If you look at the big picture, I think the mission is accomplished in terms of clearing the air, taking the stigma away, reminding folks that ESG is really important to consider, and that's what this proposal does."

The proposal, called "Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights," makes clear "that climate change and other ESG factors are often material and that in many instances fiduciaries … should consider climate change and other ESG factors in the assessment of investment risks and returns." It comes after months of stakeholder outreach on the subject and follows an executive order by President Joe Biden in May directing federal agencies to assess and mitigate financial risks related to climate change.

Julie K. Stapel, a Chicago-based partner at Morgan, Lewis & Bockius LLP, said there are some plan fiduciaries who have been waiting for the greenlight from the Labor Department on this issue for years, but the regulatory "pingpong" may give other fiduciaries pause. If a plan fiduciary is still uncertain about incorporating ESG factors into plan investment decision-making and plan lineups, "I do think the possibility of a reversal in as little as three-and-a-half years could continue to give them pause," Ms. Stapel said, referring to the 2024 president election.

But the most recent Labor Department proposal has a greater chance of surviving long term because it was proposed and could be finalized in the early days of the Biden administration, said Joshua A. Lichtenstein, an ERISA and benefits partner in New York who heads Ropes & Gray LLP's ERISA fiduciary practice. "Even if there is a change in administration in 2024, the rule will have presumably been final and effective for a long enough period of time that people will be pretty heavily invested and reliant on it, and if that's the case, then I think it becomes harder to pull back the rule," he said.

ESG investing has become more mainstream in recent years, said John Hoeppner, Chicago-based head of U.S. stewardship and sustainable investing at Legal & General Investment Management America Inc. "There's been a maturing of the whole industry while this kind of tennis back-and-forth has been happening," he said. "I don't think the debate will ever calm down, but perhaps the baseline is shifting."

Added Mr. Lichtenstein: "I think that the investment world is just moving more and more toward ESG, and so when you get to 2024, I think that if a new administration did really want to carve this back, they might face the very real commercial issue (that) it might become really limiting for ERISA plans to go back to not investing in ESG at all," he said.

It's unusual for a new administration to change a final regulation the way the Biden administration is proposing to change the Trump administration's rules on this issue, Mr. Lichtenstein noted. But the Trump administration's rules were also unusual in how quickly they were finalized — with shorter than usual comment periods — and how soon they took effect before the Biden administration took office.

However, the most recent proposal "could reflect a new norm at DOL where there will be less of an idea of deference to prior final regulations," Mr. Lichtenstein said.

The proposal is premised on the issue of financial materiality rather than the political leanings of different administrations, said Ali Khawar, acting head of the Labor Department's Employee Benefits Security Administration, at Pensions & Investments' Defined Contribution West conference in San Diego on Oct. 26.

"We try to make it clear that increasingly the market recognizes that ESG can be a material financial factor, and when it does, it's appropriate for the fiduciaries to take it into account," he said.

However, the Labor Department also "makes it clear that ESG isn't by definition material, and it isn't by definition something that you're required to always make sure that you're taking into account," he added.

"The thrust of our proposal is that the fiduciary is the person that's in the driver seat, and they are the ones that should be making that decision about whether or not it is material."

Prior to the Trump administration, the Labor Department consistently issued guidance mandating that plan fiduciaries make investment decisions solely in the interest of plan participants, but how ESG factors fit into that decision-making, as well as the tone and nuances, have varied with the issuing administration, Ms. Stapel and her Morgan Lewis colleagues explained in a blog post last year.

In 2020, under the Trump administration, the Labor Department finalized two rules — one called "Financial Factors in Selecting Plan Investments," which stipulates that ERISA plan fiduciaries cannot invest in "non-pecuniary" vehicles that sacrifice investment returns or take on additional risk; and the other, "Fiduciary Duties Regarding Proxy Voting and Shareholder Rights," which outlines the process a fiduciary must undertake when making decisions on casting a proxy vote. Both rules drew sharp criticism from the plan sponsor and sustainable investing community.

In March, the Labor Department said it would not enforce either of the Trump administration's rules.

The financial factors rule excludes a fund from being a qualified default investment alternative if its investment objectives, goals or principal investment strategy include or consider the use of one or more non-pecuniary factors. It was finalized in November 2020 and took effect Jan. 12, just days before the Biden administration took office. Mr. Biden signed an executive order on his first day in office ordering a review of the rule. It's often referred to as the "ESG rule" because the initial proposal, which was unveiled in June 2020, focused on ESG investment factors, but the final rule walked back the ESG language.

The proposal unveiled Oct. 13 would remove the special rules for QDIAs that apply under the Trump administration rule, which Mr. Hoeppner said was crucial.

QDIAs are "the crown jewel of (the defined contribution market) and maybe I had underestimated how significant calling it out or not calling it out is to set to the tone for the rest of the industry," he said. "If it's not good enough for the QDIA, then does it really make sense that it could be another option?" he said.

In May, Democrats in the Senate and House introduced a bill that is similar to the Labor Department proposal: it would amend ERISA to make clear that retirement plans may consider ESG factors in their investment decisions and that ESG investments are permitted as qualified default investment alternatives in ERISA-covered plans.

Passing a bill in Congress would provide stakeholders with more peace of mind because a law is harder to change than a regulation, sources said.

Sen. Patty Murray, D-Wash., chairwoman of the Senate Health, Education, Labor, and Pensions Committee, has welcomed the Labor Department proposal, but said Congress can do more. Ms. Murray introduced the Financial Factors in Selecting Retirement Plan Investment Act in the Senate in May with Tina Smith of Minnesota.

"It's important we give people certainty the progress represented by President Biden's proposed rule is here to stay, which is why I'm going to continue pushing to get the bill Senator Smith and I introduced passed into law," Ms. Murray said in a statement to Pensions & Investments.

But with Democrats narrowly controlling Congress, passing a bill on ESG could be difficult, sources said.

"If Congress actually acted then they could end any ambiguity, I think, but I think the likelihood of that happening is just very, very small," Mr. Lichtenstein said. "But I do think the department has done enough with this proposal where it should really increase the comfort levels for ERISA plans that want to invest ESG funds, as long as they're investing in those funds based on financial considerations."

Ms. Stapel called passing legislation on this issue "an incredibly uphill battle." She added: "I think it's so unlikely to happen that I can't even wrap my head around it. If it did happen though, I think that would be helpful because then people would not feel like they're on a four-year or eight-year pendulum."