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July 8, 2020
Proposed ERISA Regulation Regarding Investment
Introduction:

On June 30, 2020, the U.S. Department of Labor (DOL) published a proposed regulation (the Proposed Regulation) seeking to augment a fiduciary’s “investment duties” under the Employee Retirement Income Security Act of 1974 (ERISA).

The DOL proposed amending the regulations under ERISA Section 404(a) because it is “concerned that the growing emphasis on ESG investing [(i.e., taking environmental, social and governance factors into account)], and other non-pecuniary factors, may be prompting ERISA plan fiduciaries to make investment decisions for purposes distinct from their responsibility to provide benefits to participants and beneficiaries and defraying reasonable plan administration expenses.” However, the Proposed Regulation is not limited to investment decisions incorporating ESG factors, and we believe, if adopted as proposed, would have significant consequences for all ERISA investment decisions where the fiduciary has a conflict of interest.

Proposed Regulation’s ESG Focus:

In the preamble to the Proposed Regulation, the DOL made clear that “ERISA fiduciaries must never sacrifice investment returns, take on additional investment risk, or pay higher fees to promote non-pecuniary benefits or goals.” The Proposed Regulation, if adopted as proposed, would supersede the DOL’s existing “sub-regulatory” guidance on ESG investing and would be more restrictive than the current guidance in a number of significant ways.

The Proposed Regulation, if adopted as proposed, would require a fiduciary to compare ESG investments or investment courses of action that incorporate ESG factors to other available investments or investment courses of action based solely on investment return, investment risk, and fees. The Proposed Regulations would require that fiduciaries focus only on factors that “present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories”. In the preamble, the DOL cautioned that fiduciaries “must not too readily treat ESG factors as economically relevant to the particular investment choices at issue when making a decision.” The Proposed Regulation would further require fiduciaries considering ESG factors as economically significant to also examine the diversification, liquidity and risk return of other available alternative investments that would play a similar role in their plan’s portfolio.

The Proposed Regulation, if adopted as proposed, would significantly reduce the situations when the “tie breaker” might apply. Current guidance (Interpretive Bulletin 2015-1) provides that non-pecuniary considerations may be used as a tie-breaker for two investments that are “economically equivalent, with respect to return and risk to beneficiaries in the appropriate time horizon.” The Proposed Regulation would retain the “tie-breaker” mechanism, but limit its application to investment alternatives that are “economically indistinguishable”, with the preamble noting the DOL’s belief that “truly ‘economically indistinguishable’ alternative investment options should occur very rarely in practice, if at all.” The Proposed Regulation would also require fiduciaries to document why the ESG and non-ESG investments are determined to be indistinguishable and why the ESG investment is chosen.

The Proposed Regulation, if adopted as proposed, would add specific requirements for fiduciaries considering including ESG-oriented investments as a defined contribution plan investment option. The Proposed Regulation would provide that a fiduciary’s addition of prudently selected ESG-oriented investments to a defined contribution plan would not violate ERISA where:

• the fiduciary only uses objective risk-return criteria to select and monitor all investment alternatives in the plan, including ESG-oriented investment alternatives;
• the fiduciary documents its selection and monitoring of the investment; and
• the ESG-oriented investment is not added as, or a component of, a qualified default investment alternative (QDIA).

While the language of the Proposed Regulation is not entirely clear, in the preamble the DOL appears to take the position that an ESG investment option must be compared to non-ESG funds in similar asset classes.

Proposed Regulation’s Collateral Effects:

The Proposed Regulation, if adopted as proposed, would, as intended by the DOL, impede the use of ESG factors by ERISA fiduciaries and the inclusion of ESG funds as investment options on defined contribution plan platforms. However, in our view the DOL does not appear to appreciate how imposing these requirements on all fiduciary decisions would disrupt, if not prohibit, many long-standing investments and investment courses of action routinely undertaken by fiduciaries.
ERISA Section 404 imposes general duties on all fiduciaries with regard to every decision they make, and the statutory and class exemptions provided under ERISA Section 408 do not provide any relief from the requirements of ERISA Section 404. The Proposed Regulation, if adopted as proposed, would require that all fiduciary investment decisions, not just ESG-related investments:

• be based solely on their pecuniary factors (i.e., factors that present economic risks or opportunities to the plan’s assets that qualified investment professionals would treat as material economic considerations under generally accepted investment theories), and not on the basis of any non-pecuniary factor;
• be compared, on the basis of their pecuniary factors, to other available investments or investment courses of action; and
  in selecting an investment option for a defined contribution plan, only objective risk-return criteria may be used to select and monitor all investment alternatives in the plan, and the fiduciary must document its selection and monitoring of the investment.

Therefore, it is our view that, if the Proposed Regulation is adopted as proposed, every ERISA fiduciary that is relying on a class or administrative exemption that provides ERISA Section 406(b) relief will, in addition to the conditions imposed by the exemption, have to meet the conditions of the Proposed Regulation. For example:

• fiduciaries offering cash sweeps into affiliated banks or mutual funds in reliance on ERISA Section 408(b)(4) or Prohibited Transaction Exemption (PTE) 77-4 will have to compare, based solely on pecuniary factors, those investments to their competitors’ bank accounts or mutual funds and document why they selected or retained the plan’s investment in the affiliated bank account or mutual fund;
• fiduciaries using an affiliated broker/dealer in reliance on PTE 86-128 will have to compare the cost and execution quality against competing broker/dealers and in addition to the documentation required by PTE 86-128, document why the plan traded through the fiduciary’s affiliate;
• fiduciaries investing in affiliated mutual funds in reliance on PTE 77-3 or PTE 77-4 will have to compare, based solely on pecuniary factors (including fees), those investments to its competitors’ mutual funds and document why they selected and retained the plan’s investment in the affiliated fund; and
• fiduciaries investing in employer securities in reliance on ERISA Section 408(e) or maintaining an employer stock fund as an investment option in a defined contribution plan will have to compare, based solely on pecuniary factors (including the lack of diversification), investments in employer securities to other available investments and document why they selected and retained the plan’s investment in employer securities.

The DOL is accepting comments on the proposal submitted by no later than July 30, 2020.

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