Loading article...
DOL has filed a brief on the merits in Utah v. Walsh – the 26-state challenge to DOL’s ESG rule. In this article, after some background, we review the brief’s extensive discussion of DOL’s view of its ESG (environmental, social, and governance) “tiebreaker rule” and its implications for retirement plan investment.
Background
On September 21, 2023, the United States District Court for the Northern District of Texas, in Utah v. Walsh, upheld DOL’s 2022 amendment of its 2020 ESG investing and proxy voting regulation, rejecting claims by 26 states and other interested parties that that rule violated ERISA and the Administrative Procedure Act (APA). The court found that the 2022 regulation changes little in substance from the 2020 regulation and other rulemakings” and that the process by which DOL (in 2022) amended the 2020 regulation adequately addressed issues raised by plaintiffs and was therefore not “arbitrary and capricious.”
On October 30, 2023, plaintiffs in that case filed a notice of appeal with the Fifth Circuit Court of Appeals and, on January 18, 2024, filed a brief in support of their appeal with that court. On March 21, 2024, the Department of Labor filed brief in response.
DOL’s 2022 ESG regulation allows consideration of ESG factors in two circumstances.
First, where a fiduciary concludes that ESG factors (e.g., climate change risk) “are relevant to a risk and return analysis.” In this regard, the 2022 regulation explicitly affirms that “the ‘[r]isk and return factors’ on which fiduciaries base their investment decisions – wholly apart from the tiebreaker standard – ‘may include the economic effects of climate change and other environmental, social, or governance factors on the particular investment or investment course of action.’” DOL’s brief gives this illustration:
A fund might “reduc[e] or avoid[] investment in” a “fossil fuel company” because the fund “might conclude that the company’s litigation and regulatory risks are underestimated by its share price,” … given the long-term litigation and regulatory risks associated with climate change.
With respect to this issue, instead of “risk and return factors,” the (Trump DOL’s) 2020 regulation had distinguished between “pecuniary factors” – which could be considered in investment decisions – and nonpecuniary factors – which could not. While the plaintiffs in this case have challenged this change in terminology in the 2022 regulation, the lower court found that it did not affect the substance of this rule.
Second, the 2022 regulation “adopts a slightly different formulation of the longstanding tiebreaker standard.” A significant part of DOL’s brief is devoted to a detailed review of its tiebreaker standard in the 2022 regulation.
What is a tiebreaker?
To be clear, the tiebreaker rule only matters when ESG factors do not affect the risk/return analysis. In those circumstances, ESG factors are “collateral benefits other than investment returns.” Thus (for instance), where investment A is “tied” with investment B, the fiduciary chooses investment A because, in its view, investment A is more socially beneficial (a “collateral benefit”).
Continuing the “fossil fuel company” illustration above, DOL gives as an example of choosing an investment based on “collateral benefits”: “an investor might choose to ‘avoid investment in a fossil fuel company’ in order to promote ‘the collateral benefit of reducing pollution.’”
DOL’s 2022 regulation states that these collateral benefits may only be considered where the “fiduciary prudently concludes that competing investments … equally serve the financial interests of the plan over the appropriate time horizon.” [Emphasis added.]
That language is more flexible than the language in the 2020 regulation, which stated that “a fiduciary could ‘use non-pecuniary factors as the deciding factor’ only when choosing among investment options that the fiduciary was ‘unable to distinguish on the basis of pecuniary factors alone.’”
In its brief, DOL explains that this change in language was needed because “investments are frequently ‘distinguish[able],’… even when they can be expected to ‘serve the financial interests of the plan equally well.’”
When do “ties” arise?
The preamble to the 2020 regulation stated that, in DOL’s view, “true ties rarely, if ever, occur.” And plaintiffs, in their brief, argue that “it’s far from clear that true ‘ties’ exist in investing.”
Disagreeing, both with the 2020 DOL and with plaintiffs, DOL describes the context in which ties may arise as follows:
[A]s the [2022 regulation] explains, investments do not need to be “the same in each and every respect” in order to present a “tie[]”; rather, investments “may serve the financial interests of the plan equally well” even when they “differ in a wide range of attributes.” … As the Department explained in the challenged [regulation], that circumstance may be particularly likely to arise in the context of “investments outside liquid financial markets.” [Emphasis added.]
In the preamble to the 2022 regulation, DOL noted that “[s]everal … commenters did not believe a tiebreaker is necessary regardless of formulation because, in their view, ties generally do not exist, particularly in liquid financial markets.” In this regard, DOL observed:
The tiebreaker test … aligns the [final regulation] with the settled expectations of fiduciaries and others involved in the investment of assets of employee benefits plans under ERISA, especially in the multiemployer plan context. Although some fiduciaries, by the nature of their arrangements with plans, may apply investment strategies that never require them to choose between alternatives that equally serve the plan’s needs, other fiduciaries, such as those making investments outside liquid financial markets, may find the tiebreaker test useful for circumstances in which there are equally strong cases for competing investments under a risk-return analysis. [Emphasis added.]
Example – choosing between alternative, competing construction projects
To illustrate this view of the tiebreaker rule, DOL gives as an example choosing between alternative, competing construction projects:
Suppose, for example, that a fiduciary has decided to invest in a construction project. Suppose there are two competing projects and that, given the minimum investment required for either project, the plan cannot invest in both without exceeding the amount the fiduciary has determined it can prudently allocate to such projects. And suppose the two investments have the same expected risk and return over the time horizon for which plan assets are invested, such that the “fiduciary prudently concludes that” the two investments “equally serve the financial interests of the plan” …. In that scenario, the fiduciary is satisfying his duties of loyalty and prudence no matter how he resolves the choice, because an investment in either asset will equally advance the plan’s financial interests. That is all the tiebreaker standard does: It recognizes that, in that limited scenario, the duties of loyalty and prudence do not dictate what choice the fiduciary should make.
What does all this mean for non-multiemployer plans?
For defined benefit plans
As a preliminary matter, many would argue that, for single employer defined benefit plans, the issue of ESG investing is unlikely to come up for a couple of reasons. First, because financial losses in DB plans generally have to be made up by the employer/plan sponsor, it’s harder to find plaintiffs who want to bring a lawsuit. And, second, the Supreme Court has ruled (oversimplifying somewhat) that participants who are receiving their promised benefit under a DB plan generally may not bring a claim in these circumstances.
Where DB plans do undertake investments outside of a liquid financial market (e.g., investments in certain alternatives), the analysis described above could be applied.
For participant-directed DC plans
Since the investments available in participant-directed defined contribution plans’ fund menus generally are in “liquid financial markets,” we must assume that in DOL’s view tiebreakers, and the tiebreaker rule, will rarely, if ever, come up. In that circumstance, fiduciaries will have to satisfy ERISA’s prudence, diversification, and loyalty requirements on the basis of these investments’ risk/return characteristics, without regard to any “collateral benefits.”
How do we make sense of this view of the tiebreaker rule? One could argue that since DC fund assets (e.g., the stocks in an actively managed ESG stock portfolio) are bought in liquid financial markets, their risk/return characteristics (given their market-determined price) are “prudent.” Diversification would (we assume) generally be satisfied by having a broad enough choice of alternative investments (including some non-ESG investments, presumably).
The issue of loyalty would seem to be more problematic. But where there is no prohibited transaction (e.g., no self-dealing), DOL seems to be prepared to give the existence of collateral factors (e.g., a plan fiduciary’s favoring a particular sort of “collateral” ESG factor) a pass. We had assumed that might be the result of (another application, inside of a liquid financial market) the tiebreaker rule.
DOL’s presentation of the tiebreaker rule, however, raises a question in this regard: Is it DOL’s view that fund managers in liquid financial markets, in “apply[ing] investment strategies that never require them to choose between alternatives that equally serve the plan’s needs,” may only consider issues of risk and return and never consider “collateral benefits?” That is, including an ESG fund in a fund menu may only be justified on a financial basis, because the “economic effects” of the relevant ESG factors: following the “fossil fuel company” example above, the ESG fund may avoid investment in “fossil fuel companies” because of long-term litigation and regulatory risks but not because of the “collateral benefit” of reducing pollution.
DOL’s position on this issue remains somewhat obscure.
* * *
We will continue to follow this litigation.