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On January 26, 2023, a group of plaintiffs including 24 states, an energy company, an oil and gas trade association, and a plan participant filed a complaint against the Department of Labor in United States District Court for Northern District of Texas (Amarillo Division), claiming that DOL, in adopting amendments to its ESG (environmental, social, and governance) investment/proxy voting regulation, (1) exceeded its authority under ERISA and the Administrative Procedure Act (APA) and (2) violated the APA’s arbitrary and capricious standard and is irreconcilable with the language of ERISA.
While it is entirely possible this lawsuit will be tossed on motion in fairly short order, it is also possible that the court will allow it to proceed, raising questions about the viability of retirement plan ESG investment and, e.g., pro-ESG proxy voting policies that many hoped were laid to rest by DOL in its amendment of the applicable ERISA regulation at the end of last year.
In this article we review (generally) the claims made in the complaint. We begin with some brief background. We then discuss plaintiffs’ claims and their substantive arguments.
Background
There has been, since the 1990s, a tug of war between Administrations over the content of DOL guidance with respect to environmental, social, or governance (ESG) investing and plan fiduciaries’ obligations with respect to the exercise of shareholder rights (e.g., proxy voting) for plan-held securities. At the end of the Trump Administration (in 2020), DOL finalized amendments (the 2020 Rule) to its ERISA investment duties and proxy voting rules, tightening in some respects the rules with respect to ESG investing and to some extent “downplaying” fiduciaries’ obligations to exercise shareholder rights.
On taking office, President Biden issued an Executive Order instructing DOL to review the 2020 Rule. In October 2021, DOL proposed amendments to the 2020 Rule, in effect backpedaling on a number of its features, and then published final amendments to the 2020 Rule on December 1, 2022, (the 2022 Rule).
Plaintiffs’ claims
Formally, plaintiffs claim that:
The 2022 Rule conflicts with ERISA. Plaintiffs identify the 2022 Rule’s treatment of tiebreakers and its “implicit authorization [of fiduciaries] to consider nonpecuniary factors in proxy voting,” as the 2022 Rule’s “most apparent” “deviation” from the intent of ERISA’s exclusive purpose/fiduciary duty of loyalty rule.
The rule fails under the “Major Question” doctrine. This argument relies on the Supreme Court’s 2022 decision in W. Virginia v. EPA, in which it “rejected attempts to use vague grants of regulatory authority to address climate change.”
The rule violates the APA’s arbitrary and capricious standard. Plaintiffs argue that DOL’s 2022 rulemaking: (1) ignored relevant considerations, critically the possible harm to participants the rule might cause; (2) made unjustified changes to the 2020 Rule, e.g., while DOL justified its 2022 rulemaking because of the “chill” and “confusion” caused by the 2020 Rule, it “never identified who was confused, what the source of confusion was, or whether the alleged confusion caused a reduction in the financial returns for plan participants;” (3) inadequately explained other changes, e.g., the elimination of proposed disclosure of non-financial “collateral factors” considered in selecting an investment for a defined contribution plan fund menu; (4) did not consider alternatives, e.g., sub-regulatory guidance; (5) made “unreasoned changes” (see out discussion below with respect to tiebreaker documentation); (6) and had been “prejudged,” that is, before proposing the rule and soliciting comments DOL had already determined its main principles.
Plaintiffs’ arguments
Substantively, plaintiffs’ arguments focus on changes made to the 2020 Rule by the 2022 Rule in the following areas:
Elimination of pecuniary/non-pecuniary distinction.The 2022 Rule eliminated the 2020 Rule’s distinction between decisions that would be permitted if based on “pecuniary factors” or not permitted if based on “non-pecuniary factors,” substituting a statement that fiduciary decisions “must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis.” Plaintiffs argue that as a result DOL has eliminated an objective standard (pecuniary/nonpecuniary) and substituted “ill-defined, subjective ESG concepts … [and] abandons any attempt to define or advise what constitutes an ESG factor.”
Explicit permission to consider ESG factors.The 2022 Rule states that “[r]isk and return factors may include the economic effects of climate change and other environmental, social, or governance factors.” Plaintiffs argue that this language “undermines a fiduciary’s prudence obligations,” (presumably by encouraging consideration of ESG factors).
Elimination of the exclusion of ESG funds from QDIAs. The 2022 Rule eliminated the 2020 Rule’s prohibition of qualified default investment alternatives (QDIAs) (e.g., a 401(k) plan’s default target date fund) that “include, consider, or indicate the use of one or more non-pecuniary factors.” Plaintiffs argue that, given that DOL admits that QDIAs, in this context, “warrant special treatment,” DOL’s failure to provide any special treatment is arbitrary and capricious.
Treatment of tiebreakers.The 2022 Rule eliminated the 2020 Rule’s strict rules for application of a “tiebreaker exception.” The tiebreaker exception allows plan fiduciaries, in choosing between two (or more) investment alternatives, to consider non-financial “collateral” issues (such as ESG factors) where the investments are equivalent, without violating ERISA’s exclusive purpose/duty of loyalty standard. The 2020 Rule had (in its preamble) described these situations as “rare,” and had required that the fiduciary conclude that it “is unable to distinguish [between alternative investments] on the basis of pecuniary factors alone” and to thoroughly document the basis for that conclusion. The 2022 Rule provides a (significantly) more flexible tiebreaker rule, “requir[ing] the fiduciary to conclude prudently that competing investments … equally serve the financial interests of the plan over the appropriate time horizon.”
Plaintiffs argue that these changes “not only loosen the statutory and regulatory restraints on fiduciaries to consider ESG factors, [they] will allow fiduciaries and investment managers to potentially substitute their own ESG policy preferences under the guise making a risk-return determination about an investment.”
Further, according to plaintiffs, DOL justifies the elimination of the tiebreaker documentation requirement “by saying its inclusion would unduly burden fiduciaries who sought to use the tiebreaker.” Plaintiffs, however, argue that, because the investments under consideration “equally serve the financial interests of the plan over the appropriate time horizon,” selection of the ESG investment provides no benefit to the plan (vs. the “equal” alternative) and therefore the additional burden/cost of documenting the reasons for selecting it cannot justify the elimination of this requirement of the 2020 Rule.
The 2021 proposal included a requirement that, where the tiebreaker rule was used in a participant-directed DC plan, e.g., to include an ESG fund in the fund menu, “the plan fiduciary must ensure that the collateral-benefit characteristic of the fund [e.g., that it is an ESG fund] … is prominently displayed in disclosure materials provided to participants and beneficiaries.” The final 2022 Rule did not include this special disclosure rule. Plaintiffs argue that DOL did not give a reason for excluding this requirement from the final 2022 Rule, instead “simply recit[ing] the arguments from commenters both for and against its inclusion.”
Elimination of the rule prohibiting proxy voting to promote non-pecuniary goals.Finally, with respect to the proxy voting provisions of the 2022 Rule, plaintiffs target the elimination of the language in the 2020 Rule that prohibited fiduciaries from exercising shareholder rights to “promote non-pecuniary benefits or goals unrelated to those financial interests of the plan’s participants and beneficiaries.” This change, they argue, implicitly authorizes fiduciaries “to consider nonpecuniary factors in proxy voting and exercising shareholder rights,” in violation of ERISA’s exclusive purpose/fiduciary duty of loyalty rule.
Claim for relief
Plaintiffs have asked the court to: postpone the 2022 Rule’s effective date (currently the rule is generally effective January 30, 2023); declare it arbitrary and capricious/contrary to law; hold it unlawful and set it aside; and preliminarily and permanently enjoin DOL from taking any action under it.
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We have tried to present the main outlines of plaintiffs’ claims. The case presents a number of other issues – most obviously plaintiffs’ standing to sue. Some of plaintiffs’ arguments are interesting, others seem like a stretch.
It is interesting to compare this case with current litigation over DOL’s Fiduciary Advice Prohibited Transaction Exemption. In the PTE litigation, plaintiffs are arguing that DOL violated the APA and ERISA by tightening its fiduciary advice rule. Here, plaintiffs are arguing that DOL violated the APA and ERISA by un-tightening its exclusive purpose/fiduciary duty of loyalty rule. In both cases, DOL is attempting via regulation to fundamentally revise regulatory positions it has taken in the past – an inherently awkward project. If DOL was “wrong” in its earlier guidance, what is to say it is not wrong in its new guidance, or that it has authority to decide the question at all?
The principal question at the outset will be whether the court will be willing to consider this case at all. We can expect a motion to dismiss from DOL. What the court will do with that is, at the moment, anybody’s guess.
We will continue to follow these issues.