The DOL’s ESG Proposal: Overview of Key Themes in Comment Letters
By George Michael Gerstein
Co-Chair, Fiduciary Governance, Stradley Ronon Stevens & Young, LLP*
September 17, 2020
The U.S. Department of Labor (DOL)’s proposal, “Financial Factors in Selecting Plan Investments,” relates to environmental, social and governance (ESG) investing on behalf of employee benefit plans subject to ERISA, and investment funds that hold “plan assets” for purposes of ERISA. Considering strong global trends toward greater adoption of ESG strategies by institutional investors, it should come as little surprise that the proposal elicited thousands of comment letters, including a comment letter by the IAA. In reviewing a sample of 22 letters, the vast majority of which were from investment managers and trade associations, the following themes and points proved popular and salient:
- Meaning of “ESG”: Commenters said that the proposal shows a fundamental misunderstanding on the part of the DOL with respect to ESG investment strategies. One noted that it is unhelpful for the proposal’s preamble to generalize that ESG investing is more expensive with lower returns than non-ESG investing, yet at the same time also acknowledge that there is no consensus over the definition of “ESG investing.” Another commenter pointed out that the DOL highlighted vast inflows into “ESG funds,” but did not also mention that most of the inflows are attributable to strategies that incorporate ESG considerations for pecuniary reasons. Commenters called on the DOL to clarify in any final rulemaking the terms “ESG” and “ESG fund,” as “ESG” is often used to refer to a wide range of strategies – ranging from pecuniary-based to non-pecuniary. Others noted that an “ESG-themed” product does not preclude it from having pecuniary investment objectives, such as to maximize total return and to outperform broad market indices. In one commenter’s view, the proposal may also be interpreted as limiting the use of any investment strategy that is not expected to perform in line with (or outperform) a broad market index (g., sector-focused or theme-focused funds and strategies).
- Pecuniary ESG Factors: Commenters stated that the proposal assumes that ESG factors are rarely, if ever, pecuniary in nature. They observed that this assumption flies in the face of myriad studies that evidence ESG as being material to investment performance. One cited example is management dysfunction at an issuer, which the commenter claimed virtually all investment managers would take into account under generally accepted investment theories, even though governance is technically an “ESG” factor. Nearly all commenters stressed that some ESG strategies treat ESG factors as material investment risks and opportunities. Under these strategies, ESG factors are carefully considered under generally accepted investment theories in the investment process to help reduce risk and improve performance. ESG factors are economically relevant because they can impact the value of investments, especially in the long term. Commenters were similarly quick to point out that empirical evidence does not support the notion that ESG considerations adversely affect performance. Moreover, some noted that ESG funds can operate as a valuable hedge, including against performance by certain sectors or against market downturns. Various commenters criticized the proposal for treating all ESG factors as if they were merely designed to further some social or political objective. According to these commenters, the proposal misfocuses on ESG status rather than pecuniary status. To that end, commenters suggested that the DOL should instead draw the key distinction at whether the factor is pecuniary or non-pecuniary in nature.
- QDIA Exclusion: Under the proposal, an ESG “or similarly oriented investment mandate alternative” may not be added as, or as a component of, a qualified default investment alternative, or QDIA. Commenters marshalled numerous arguments to counter the proposal’s exclusion of ESG strategies within QDIAs, including: first, the exclusion effectively overrules investment professionals applying generally accepted investment theories because it would bar fiduciaries from considering a pecuniary ESG factor; second, the DOL should treat all pecuniary factors alike (an investment manager to a QDIA should be free to select an ESG component investment solely for pecuniary reasons); third, a fiduciary should be able to consider ESG factors if it can satisfy its fiduciary duties under ERISA in doing so; fourth, a plan fiduciary’s selection of a QDIA that fails to consider material ESG criteria in its fundamental analysis could be viewed as imprudent and potentially in breach of its fiduciary duties; and, fifth, if the DOL wishes to address whether ESG can be part of a QDIA, the proper place for that is under the QDIA regulations.
- Affirmative Duty to Consider Pecuniary ESG Factors: Many commenters argued that the DOL should clarify that fiduciaries must integrate material factors into investment decisions, including material ESG factors (relatedly, the commenters asked the DOL to expressly acknowledge that ESG may in fact be a material factor).
- Proposal’s Complexity Drives Up Cost: Several commenters stressed the proposal’s complexity and costs. For example, they stated that the proposal’s added documentation and recordkeeping requirements would drive up cost, which would particularly impact small plans. They also emphasized that the DOL did not fully address in the regulatory impact analysis the added burdens imposed on ERISA plans and fiduciaries, such as the fact that plan sponsors would incur significant and ongoing costs to conform their investment decisions to meet the proposal’s new documentation and analysis requirements. Moreover, one commenter said that, even if a plan sponsor believes it has not considered ESG factors in its investment duties, it may still feel compelled to conduct a review of existing investment option documents and investment decisions to determine whether it is ensnared by the rule. In addition, according to several commenters, the requirements to compare investments or investment courses of action would not only be costly to administer, but practically difficult to implement. They said that fiduciaries following a prudent process, as already required under ERISA, understand their obligations, and the increased recordkeeping requirement would simply increase costs without advancing the plan’s financial returns.
- Proposal Invites Litigation: Several commenters argued that the proposal’s complexity and ambiguity would increase litigation risk. For example, because the proposal seems to prescribe principles and standards unique to ESG investing, commenters said that the rule creates uncertainty and invites litigation over whether a given investment program falls within the ESG rubric, a problem only magnified by the confusion and uncertainty over what constitutes “ESG” investing. As the DOL itself acknowledged, ESG investing does not have a uniform meaning and the terminology is evolving. Moreover, commenters said that it is unclear that the proposal is even limited to ESG investing. One commenter said that the interpretation of investment duties could be read as applying broadly to investment decisions made by ERISA fiduciaries and the proposed rule provisions may create the perception that a mandatory checklist applies broadly to ERISA fiduciary investment decision-making. Commenters noted that other relevant facts and circumstances have not been addressed in the enumerated checklist for compliance in the proposed rule text, including the long-term horizon of returns, further exposing fiduciaries to risk. Finally, some commenters warned that the proposal’s complex application to defined contribution plans would encourage the plaintiffs’ bar to second guess investment lineups.
- Proposal Inapposite with ERISA: For some commenters, the proposal contravenes the letter and spirit of ERISA. One pointed out that Section 404(a)(1)(B) of ERISA reflects Congress’ express rejection of the notion of having the DOL dictate the types of investments and investment strategies that ERISA plans must adopt and avoid. According to this commenter, it appears from the proposal that the DOL no longer trusts generally accepted investment theories to guide fiduciaries in discerning when ESG factors are used to promote the pecuniary interests of the plan. Moreover, the proposal broadly assumes that all ESG considerations are non-pecuniary unless proven otherwise. Commenters said that this presumption, coupled with the proposed comparison requirements, are not supported by the more flexible language in ERISA, which allows fiduciaries to consider all relevant factors when making investment decisions. It was stressed that ERISA neither favors nor disfavors ESG investing. Commenters noted that any investment decision by an ERISA fiduciary is subject to the same fiduciary principles embodied in the duties of prudence and loyalty. Commenters also said that the proposal breaks from this bedrock principle by suggesting that ESG investing is inherently suspect. They argued that the consideration of ESG factors that are pecuniary-based is consistent with ERISA’s duty of loyalty because the motive is to improve risk-adjusted returns.
- The Tie-Breaker Test: Under past DOL guidance, known as the “tie-breaker” or “all-things-being-equal” test, a fiduciary may break a tie between investments by relying on a non-pecuniary factor. More recent DOL guidance requires the investments to be “economically indistinguishable.” The “economically indistinguishable” standard, which is also used in the proposal, elicited many comments. In response to the DOL’s question of whether satisfaction of the tie-breaker test was rare in practice, one commenter responded that a prudent ERISA fiduciary investment process typically results in multiple investments that meet the plan’s investment criteria (e., they are “indistinguishable”) and, therefore, they are all equally prudent. ERISA does not require selecting the “best” of these. Yet another commenter noted that the tie-breaker test was more theoretical than anything. Another concern that was raised was whether the proposal imposed the tie-breaker test on all ESG investment decisions, even ESG factors that are material to investment performance (i.e., pecuniary-based). Multiple commenters wondered whether the proposal’s interpretation of the tie-breaker test would be impossible to satisfy (one noted that the proposal makes it effectively a per se breach of fiduciary duty to consider any non-pecuniary factors even if, as recognized under Interpretive Bulletin 2015-01, such factors could be appropriately recognized as long as they did not subordinate the interests of the plan to unrelated objectives). Commenters also argued that the proposal would create new burdens for fiduciaries who use the tie-breaker test, which would have a chilling effect, and the estimated costs for complying with the proposed documentation requirements are significantly understated. Lastly, commenters argued that the DOL should apply the traditional “all-things-being-equal” tie-breaker test to the selection of plan investment options in defined contribution plan lineups.
- Suggestions for Improvement: Commenters made various suggestions on how the DOL could make the proposal more workable:
- Limit the proposal’s application to funds that use ESG factors in their name, investment objective or principal investment strategy;
- Focus instead on full and transparent disclosure. The DOL’s proposal is inconsistent with efforts of the Securities and Exchange Commission’s (SEC’s) Investor Advisory Committee, which recently recommended that the SEC begin an effort to update the reporting requirements of issuers to include material ESG factors. Commenter suggested that a more measured and disclosure-driven approach to the oversight and regulation of ESG-oriented investment strategies is appropriate, rather than, as the proposal does, broadly suggesting ESG is illegitimate for ERISA plan investors. A disclosure-based focus would also be in keeping with the European Union’s approach. This is particularly relevant for global investment managers, who may be forced to treat ERISA investors differently than all other investors, potentially leading to higher costs and fewer options for ERISA plans; and
- Require an ERISA fiduciary to document that, based on consideration of pecuniary factors (which may include ESG factors that meet the standards of the proposed rule), the fiduciary has concluded that the investment is prudent and that any consideration of non-pecuniary factors is not sacrificing investment returns or accepting increased risk.
The DOL is in the process of reviewing the comment letters. Given the prevalence of ESG investing, there are many stakeholders that are paying close attention to future DOL action in this area.
* George Michael Gerstein is co-chair of the fiduciary governance group at Stradley Ronon Stevens & Young, LLP. This article is for general information purposes and is not intended to be and should not be taken as legal or other advice.
TAGS: Columns, Guest Column, ESG, DOL