Key Takeaways

• The Proposed Regulation presumes that ESG factors have a financial impact, affecting the risk/return characteristics of an investment and the exercise of shareholder rights.
• The Proposed Regulation removes the special ESG record-keeping and documentation requirements.
• The Proposed Regulations will affect investment managers that market to ERISA plans as well as investment managers that act as ERISA fiduciaries.

On October 14, 2021 the U.S. Department of Labor (the “DOL”) proposed a new regulation titled “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights” (the “Proposed Regulation”), which will replace the two Trump-era regulations regarding environmental, social and governance (“ESG”) considerations when (1) investing and (2) exercising shareholder rights, both of which are currently subject to a non-enforcement policy.

If adopted as proposed, the Proposed Regulation would provide comfort to persons acting as fiduciaries under the Employee Retirement Income Security Act of 1974 (“ERISA”) that ESG factors may be considered when determining plan investments. The Proposed Regulation effectively creates a presumption that ESG factors affect the risk and/or return of an investment. The Proposed Regulation states that a prudent fiduciary may consider any factors material to the risk-return analysis and provides as potential examples: (i) climate change related factors; (ii) governance factors; and (iii) workforce practices.

The general framework governing an ERISA fiduciary’s investment decisions remains unchanged. A fiduciary may not sacrifice investment return or increase investment risk to promote non-financial goals. However, the Proposed Regulation creates the presumption that the risk/return analysis “may often require an evaluation of the economic effects of climate change and other environmental, social, or governance factors on the particular investment or investment course of action,” such that fiduciaries are no longer required to demonstrate that ESG factors in fact impact the risk/return analysis. The Proposed Regulation also amends the tie-breaker rule, so that two investments no longer need to be “indistinguishable” based on financial factors in order to utilize non-financial factors as a tie breaker; rather, if a fiduciary concludes two investments “equally serve the financial interests of the plan,” the fiduciary may make the investment selection based on collateral benefits. The Proposed Regulation also does not restrict ESG funds from being designated investment alternatives, but does require that, if a plan fiduciary is choosing a designated investment alternative in part based on collateral benefits, such collateral benefit characteristics must be prominently displayed in the disclosure materials provided to plan participants.

Although there is significant overlap between the Proposed Regulation and the Trump-era regulation regarding proxy voting and shareholder rights, the presumption in the Proposed Regulation that ESG factors impact the risk/return characteristics of an investment should permit ERISA fiduciaries to incorporate ESG factors into their proxy voting policies. The Proposed Regulation provides that, when deciding whether to exercise shareholder rights and when exercising those rights, a plan fiduciary’s evaluation “must be based on risk and return factors that the fiduciary prudently determines are material to investment value, using appropriate investment horizons consistent with the plan’s investment objectives.. Whether any particular consideration is such a factor depends on the individual facts and circumstances” and may include ESG factors.
Finally, the Proposed Regulation removes the special ESG record-keeping and documentation requirements, stating that the normal record-keeping and documentation are sufficient to demonstrate compliance with ERISA.

If you would like our assistance in commenting on the proposal, or if you have any questions on the matter, please contact S. John Ryan at (212) 574-1679, Michael O’Brien at (212) 574-1505, or Bradley Fay at (212) 574-1429.