Seyfarth Synopsis: For those of you following the saga of ERISA’s fiduciary duties and ESG investing, we are nearing a possible finish line. The latest turn in the saga came when the DOL issued a new set of proposed regulations this month. The approach taken by the DOL comes as no surprise. Looking at the broader ESG shifts in the regulatory environment, the DOL regulations create a symmetry with SEC activities under Gary Gensler’s helm as the SEC’s taken a very vocal approach on the role of ESG factors in an investor’s ability to assess the value of an investment. We further discuss the evolution of the market’s approach to ESG factors in our four-part series you can access here.

The Road to the Latest Swing

Avid subscribers to Beneficially Yours may recall where we started in June 2020 when the DOL issued proposed regulations addressing how ERISA fiduciaries should evaluate an investment or investment strategy based on environmental, social or governance (ESG) factors. Summarized here and here, that guidance indicated that ERISA fiduciaries should focus on pecuniary factors when evaluating an investment or investment strategy, and it cast doubt on whether ESG factors would meet that standard.

The DOL pushed that further in August 2020 with proposed rules described here on a fiduciary responsibility when exercising shareholder rights (including voting proxies) for the plan’s assets. When these rules were finalized and published in November and December 2020 (discussed here and here), they indicated that plan fiduciaries must evaluate investments and investment strategies based solely on pecuniary factors, made it clear that, in DOL’s eyes, ESG factors are not pecuniary in nature, and severely restricted fiduciaries’ ability to vote proxies for the plan’s assets. The new Administration sidelined those 2020 regulations (discussed here), and in March 2021, the DOL announced that it would not enforce those regulations.

The New Proposal’s Approach

Staying grounded in ERISA’s fiduciary duties of loyalty and prudence, the new proposed rules recognize the evolving importance of ESG factors when investing. While the DOL still emphasizes the importance of the risk-return analysis of a proposed investment, the proposal is clear that such an analysis may require evaluating the potential economic effects of climate change and other ESG factors on the proposed investment. This echoes the SEC’s views on ESG. The proposal also specifically permits ESG factors as a material consideration for plan fiduciaries. The DOL explains that “a fiduciary may consider any factor material to the risk-return analysis, including climate change and other ESG factors. … [M]aterial climate change and other ESG factors are no different than other ‘traditional’ material risk-return factors … .” Thus, under ERISA, if a fiduciary prudently concludes that a climate change or other ESG factor is material to an investment or investment course of action under consideration, the fiduciary can and should consider it and act accordingly, as would be the case with respect to any material risk-return factor.”

To demonstrate the potential economic materiality of these factors, the provision lays out examples in each of the E, S and G areas. On the environmental side, the DOL noted that climate change is already imposing significant economic consequences on businesses resulting from, for example, extreme weather damage to physical assets and disruption of business productivity and supply chains. The DOL also noted that proposed governmental regulations and policies (for example, to address green-house gas emissions, and to shift away from carbon intensive investments) could impact an entity’s value. Because pension plans have long term investment horizons, the expected effects of climate change is especially pertinent to the plans’ projected returns.

The DOL noted that governance factors involving board composition, executive compensation practices, corporate decision-making and compliance are also potential material considerations when evaluating an investment. Similarly, workforce diversity and inclusion, training and labor relations could be material factors. The proposed rule acknowledges that financial risk resulting from each of these areas can have a significant impact on reducing volatility and mitigating long term risks to plan assets and should be taken into consideration when selecting investments and investment strategy.

Key Changes

Tie-Break Standard Remains with a Clarification. The proposed rules do retain an element of the old tie-breaking standards, but clarify that a fiduciary is not prohibited from selecting an investment due to any collateral benefits other than investment returns — which was perceived under the 2020 regulations as targeting ESG factors. However, if collateral factors (for example, the ESG factors) tipped the scale in favor of including an investment option in the investment line-up of a participant-directed defined contribution plan, the fiduciaries must ensure that those collateral factors are prominently displayed in the disclosures provided to participants.

Record-keeping and Disclosure Requirements. The proposal also eliminates the special documentation requirement when the fiduciary has concluded pecuniary factors alone were insufficient to make a decision. The prosed rules recognized that such a requirement was not necessary given the existing fiduciary obligations, which are commonly understood to include documenting fiduciary decisions.

QDIAs are a Go. The proposed rules also eliminate the prohibition on ERISA fiduciaries designating investments that use ESG metrics as a plan’s QDIA, as long as those funds otherwise meet the standards.

Proxy Rules Have Give. The proposed rules also address the exercising of shareholder rights (including proxy voting) aspects of the 2020 regulations. The new proposed rules emphasize that the fiduciary duty to manage plan assets includes exercising the shareholder rights associated with those assets, and fiduciaries should conscientiously exercise those rights to protect the interests of the plan participants. As a result, fiduciaries should weigh the cost and effort of voting proxies against the significance of the issue to the plan, and apply the general fiduciary principles.

The proposal eliminates several provisions that were couched as “safe harbors” in the current rule based on the DOL’s concern that they were being construed as permission for fiduciaries to abstain from voting proxy without properly considering the plan’s interests as a shareholder. In addition, the proposed rule prohibits a fiduciary from following the recommendations of a proxy advisory firm or other service provider unless the fiduciary determines that its proxy voting guidelines are consistent with the guidance in the proposal.

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If you would like to discuss how these proposed rules could impact you, contact your Seyfarth Shaw employee benefits attorney. If you would like to comment on the proposal, your comments must be summited to the DOL by December 13, 2021.

Seyfarth Synopsis: The ever evolving landscape of environmental, social and governance (ESG) factors and 401(k) plan investment options may have just become even more complicated.

As we’ve covered on our blog over the last few years, the DOL’s guidance on whether environmental, social and governance (ESG) investments are an appropriate investment for ERISA plans has changed significantly. (See our prior blog posts here, here, and here for more background on that complicated history.) The Securities and Exchange Commission (“SEC”) has added a new potential twist that could place fiduciaries of retirement plans, like 401(k) plans, and the Board of Directors of companies that sponsor such plans in a very difficult position. Specifically, the SEC recently released correspondence related to its denial of the request from two different companies to exclude from its proxy materials a shareholder’s proposal concerning the investment options under the company’s retirement plan.

To read the full legal update, click here.

Seyfarth Synopsis: In keeping with their recent more vocal stance on fiduciary duties, the Department of Labor has weighed in on the wisdom of 401(k) plans including an ESG fund or a crypto investment option in its line-up. And, it’s complicated.

As we’ve covered in this space, over the last few years the DOL has opined on the type of investment that would be appropriate for a fiduciary to include in a 401(k) plan’s line-up. For example, the DOL’s thinking on whether an ESG-focused investment is appropriate has evolved over this time period, from a hostile outlook to one that acknowledges that ESG factors may be pecuniary in nature, requiring an evaluation of those factors. [See our prior posts here and here for more background on that complicated history.] In fact, following their newly announced attitude toward ESG funds, in February the DOL’s EBSA issued a Request for Information to solicit input on how retirement savings could be impacted by “climate-related financial risk” and what actions the EBSA should be doing in that regard. The RFI focused on whether the EBSA should be collecting data on plans’ climate-related financial risk and whether the Form 5500 should be used for this task. This latest issuance from the DOL seems to mark a full about face on their ESG views, from one which almost forbids its consideration to one which mandates it.

One might have thought that following the DOL’s more open attitude toward ESG-focused investment options in 401(k) plans, they would be content to just let the prudent fiduciary standards generally apply to selection of investment options. That turns out not to be the case. The DOL has just issued a Compliance Assistance Release on 401(k) investments in crypto-currencies, including a wide range of digital assets. Contrary to their ESG views, in this case, the DOL expressly warns fiduciaries about including such an offering or risk personal liability. They cite such concerns as the speculative and volatile nature of, and the valuation concerns with, cryptocurrency, the difficulty in recordkeeping and custodying such assets, as well as the evolving regulatory environment. The agency also notes that not all 401(k) participants are sophisticated investors and evaluating whether they should invest their retirement savings in crypto would be extraordinarily difficult for them. Participants may surmise that because such a fund is offered in their plan, means it is an appropriate and prudent option for their own retirement savings.

The DOL leaves us with an ominous warning that it will conduct a program to investigate plans that offer investments in cryptocurrencies and related products to take “appropriate action to protect the interests of plan participants and beneficiaries.”

Seyfarth Synopsis: Reminiscent of the DOL’s about-face on ESG investing by ERISA fiduciaries [discussed here], on December 21st the DOL issued a “supplemental statement” on its view of the use of private equity investments in participant-directed retirement plans, such as 401(k) plans. 

As a refresh, in June 2020 the DOL issued an Information Letter to two private equity firms that sanctioned the use of private equity investments as a component of certain designated investment alternatives, such as professionally managed target date funds and balanced funds, offered to participants in individual account plans. The firms represented that including private equity as a component of a larger managed fund allows participants access to equities outside of publicly traded securities with a potential of larger returns. The requestors also indicated that plan fiduciaries were concerned about liability for including private equity even where they believed the investment was prudent. In response to the request and representations, and recognizing the difficulties inherent in private equity with liquidity and valuation, the DOL nonetheless concluded that “a plan fiduciary would not, in the view of the Department, violate the fiduciary’s duties under section 403 and 404 of ERISA solely because the fiduciary offers a professionally managed asset allocation fund with a private equity component as a designated investment alternative for an ERISA covered individual account plan in the manner described in this letter.”

Fast forward a year and a half, and under a new Administration, the DOL has seen the need to issue a supplemental statement out of a concern that the Information Letter could be marketed as endorsing the use of private equity investments. The DOL stated that it has received considerable feedback from a number of stakeholders regarding the Information Letter.  It also noted that after its issuance of the Information Letter, the SEC had issued its own “Risk Alert” that highlighted compliance issues discovered in examinations of registered investment advisors that manage private equity funds. In response, the DOL felt the need to issue the supplemental statement so that the Information Letter is not misread as suggesting that private equity “as a component of a designated investment alternative — is generally appropriate for a typical 401(k) plan.”

The DOL is now emphasizing its concerns with adequate disclosure and valuation of private equity. It also stresses the importance of obtaining assistance from a qualified investment adviser where the responsible fiduciary does not have the skills, knowledge and experience to evaluate the prudence of the private equity component and the continual monitoring of such an investment. The DOL further notes that the Information Letter should be read in the context of use of private equity investments in a defined contribution plan where the sponsor also offers a defined benefit plan that uses private equity. Finally, the DOL states its own concern that fiduciaries of small plans will not typically have the expertise in private equity to be able to make the evaluation and monitoring determinations needed to make a prudent decision.

Bottom line: Offering a private equity component in a designated investment alternative in a participant-directed retirement plan is not endorsed by the DOL. Such an offering should be limited to one within a large plan, that perhaps parallels investments in a companion defined benefit plan, and the risks of which have been vetted (and are continually monitored) by sophisticated plan fiduciaries with investment experience in private equity.