Key Provisions Will Add Burdens to Fiduciaries Considering ESG Investments
On November 13, the US Department of Labor (DOL) published a release (the “Release”) setting out its final rule on fiduciary standards as they affect environmental, social and governance (ESG) investing strategies. The final rules discourage use of so-called “non-pecuniary” factors by fiduciaries, posing a challenge to a variety of ESG investing strategies. The key provisions of the rule will take effect on January 13, 2021 (60 days after publication in the Federal Register). The DOL received over 8,000 comments on its June 2020 proposal, most of which opposed its key elements. Nevertheless, the DOL adopted the rule substantially as proposed. We reviewed the proposed rule in a previous Practus Perspectives post, The U.S. Department of Labor’s New Investment Duties Rule.
In the final Release, DOL defends its decision to proceed with the rule despite the criticisms brought by investment industry participants, as well as advocacy groups for ESG and sustainable investing. DOL acknowledged the lack of evidence that the growth of ESG investing has adversely impacted beneficiaries; nevertheless, it insisted that this is not grounds to ignore its obligations to correct ambiguities in past guidance that could impact beneficiaries in the future.
ERISA fiduciaries will need to follow developments with these rules carefully. They could be revised by the incoming Biden Administration, but if changes are extensive, a new rule-making would be required. In the meantime, it is important for ERISA fiduciaries to carefully weigh the effects of the new rules and to consider updating their processes and record-keeping practices to conform with the revised standards.
What Changes with the New Fiduciary Rule?
Final Rule: The new rule accomplishes the following.
- Rephrases DOL’s interpretation of statutory requirements to make clear that fiduciaries must fulfill their statutory duties of care and loyalty by choosing investments based on the best interests of the plan beneficiaries and subordinating all other considerations, including other social and political goals, to the financial interests of these beneficiaries (the so-called “exclusive purpose rule”).
- Clarifies that duties under the “exclusive purpose rule” prohibit fiduciaries from choosing investments based on “non-pecuniary” factors, such as ESG factors, unless ESG considerations are themselves “economic” factors, i.e. essential to make an evaluation of the financial risk and reward mix of a particular investment.
- Requires fiduciaries to evaluate competing investments and make investment choices based on “non-pecuniary” factors only when the economic characteristics of competing investments from a risk-reward standpoint are equal (so called “tie-breaker” rule).
- Prohibits fiduciaries from offering ESG-focused options as qualified default investment alternatives (QDIAs) in individually-managed accounts.
The final rule makes several small changes to the original proposal. It incorporates several changes to language in Rule 404a-1(b) to remove some circularity of definitions of the duty of loyalty and to affirm that Rule 404a-1(b)(ii) constitutes a safe harbor and not a minimum requirement for giving “adequate consideration” for purposes of the fiduciary standard. The final rule removes any express regulatory reference to ESG factors but leaves intact the concept of “non-pecuniary factors” in Rule 404a-1(c).
As we recommended in July, ERISA fiduciaries and investment managers should continue to assess their policies, procedures and practices to gain a better understanding of where they stand vis-à-vis these DOL expectations. Below are some matters that fund managers and fiduciaries should consider:
- ESG funds should reassess client disclosures with respect to the impact of ESG factors on financial returns and risks.
- Pension fund trustees and investment advisors should modify communications to clients that desire to have exposure to funds that use ESG factors.
- Fund managers should review their investment analyses and techniques to consider whether the use of “negative screens” may not be compatible with their client’s obligations. A similar analysis would have to be considered with respect to “positive screens.”
- Funds that fully “integrate” ESG factors into their selection process will need to be careful in describing how these factors aid in assessing the material economic factors that are pecuniary in nature.
- Funds that focus on governance (“G”) will need to sharpen their justification for how better governance impacts long-term performance.
- Fund sponsors can also expect that fiduciaries will more closely scrutinize how funds use third-party rating services to rank investments based on ESG factors.
In the Release, DOL expressed skepticism about third-party ESG ratings and standard-setting initiatives. Different ratings services define and use ESG factors a bit differently, meaning that a corporate issuer could receive very different scores from different services. This variability makes third-party rankings vulnerable to the criticism that they are inherently “subjective” and thus outsourcing ESG assessment to a third-party rating service could raise significant issues under the final rule. Moreover, ratings services typically do not rate corporate issuers based on what DOL would call pecuniary factors.
Please talk to one of our experienced lawyers at Practus LLP to make sure that your investment methodologies and your management processes are able to cope with the additional scrutiny that the DOL may apply to use of so-called “non-pecuniary factors” such as ESG.
We have the experience and the knowledge to help you navigate these choppy waters and help you develop cost-effective solutions.
About the Author
As a general counsel and corporate lawyer, Richard Pasquier has over 25 years of business law experience helping clients navigate complex issues like business transactions, commercial contracts, litigation, compliance, regulatory affairs, human resources, and labor matters.
In addition to his deep background in governmental affairs, Rick’s pro-bono leadership in non-profit organizations speaks to his commitment to make the world a better place. He serves as an adjunct professor at Temple University and is currently working to complete his PhD. in political science (December 2020).