ESG investing – sponsor fiduciary risk
In the controversy over ESG (environmental, social, governance) investing and (ESG-related) proxy voting, our focus is generally on sponsor liability. So, while we are following litigation over DOL’s recent amendment of its rule on these issues, we are generally more interested in cases like Spence v. American Airlines, in which a participant is suing (among others) the plan sponsor and sponsor fiduciaries over their (alleged) inclusion of ESG or ESG-influenced funds in the fund menu. And while (as we discuss in our article on it), that lawsuit is likely to be dismissed, given the incentives, it is likely that plaintiffs lawyers will continue to scrutinize sponsor ESG plan investment policy for vulnerabilities.
We’re going to do two general articles on these issues, strictly from the point of view of the sponsor. This first one is on ESG investing. The second one will be on ESG-related proxy voting.
For purposes of this article, we are going to analyze these issues in the specific context of a participant lawsuit against a sponsor/sponsor fiduciary, challenging either: (1) the inclusion of an ESG fund – defined as a fund that explicitly makes investments in portfolio companies based on some version of ESG criteria – in the plan’s fund menu (in the case of a participant-directed defined contribution plan); or (2) where there is no participant direction, the inclusion of such a fund, or a direct “ESG-influenced” investment, in the plan’s asset portfolio (in the case of, e.g., a defined benefit plan).
In that regard, we will consider both DOL’s position (set forth in its amended ESG regulation) and alternative challenges a participant might bring. Ordinarily, courts would defer to DOL’s interpretation of ERISA. But the issue of ESG investing has been so fraught, and DOL has changed its position so many times, that it is entirely possible the courts will take seriously an alternative theory of these issues in, e.g., a participant lawsuit.
We begin with a discussion of the two ERISA fiduciary duties typically implicated in ERISA fiduciary litigation, the duty of prudence and the duty of loyalty. We conclude with a discussion of the fiduciary duty to diversify which is both a separate fiduciary duty and an element of the duty of prudence.
The duty of prudence – DOL’s view
Under the (current) final DOL regulation, the decision to include a fund (ESG or non-ESG) in a participant-directed plan fund menu or in a DB plan fund portfolio must be “based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis.” In this regard, “[r]isk and return factors may include the economic effects of climate change and other environmental, social, or governance factors.”
More specifically, the fiduciary must give “appropriate consideration to the role the investment or investment course of action plays in that portion of the plan’s investment portfolio or menu with respect to which the fiduciary has investment duties.” In this regard, “appropriate consideration’’ includes a determination that the investment furthers the purposes of the plan, considering the investment’s risk/return opportunity vs. other “reasonably available alternatives.” And, with respect to non-participant-directed DC plans (e.g., a DB plan), the fiduciary must consider diversification, liquidity requirements, and plan funding objectives.
This all sounds a little theoretical. Pragmatically, the decision to include an ESG fund in a fund menu or an ESG investment (e.g., a solar company) in the plan’s portfolio must be financially/economically justified.
Assuming that these funds/investments are all generally priced in a sufficiently robust market, and (critically) assuming that the plan fund menu, or (where there is no participant direction) plan investments, are adequately diversified, this “financially/economically justified” test should be relatively easy to meet. To be clear: any investment is “justified” at an appropriate price (see our discussion of Fifth Third Bancorp et al. V. Dudenhoefferbelow). So, investments in securities of a company that are priced in an efficient market are – all else equal – justified, where (as discussed below) “all else” generally means adequate diversification and no “duty of loyalty” issue.
Nevertheless, the better part of wisdom is that, where an ESG investment is made, the plan fiduciary should recite (in minutes) the “financial/economic” reason for making it.
The courts’ view – Dudenhoeffer
DOL has (as described above) a somewhat elaborate test for what investment prudence requires. The Supreme Court, in its unanimous opinion in Fifth Third Bancorp et al. V. Dudenhoeffer, provides a more straightforward test. The critical additional element recognized by the court is that investments typically are made in a (liquid, open) market that determines the value of each investment (e.g., its share price).
In that context, the Court found that prudence requires two things: (1) satisfaction of ERISA’s diversification requirement (about which more below); and (2) fair market value. That is, (assuming ERISA’s diversification standard is satisfied) the determination of whether a particular investment is “prudent” depends solely on its price (relative to the price of alternative investments). And in that regard: “Where a stock is publicly traded, allegations that a fiduciary should have recognized on the basis of publicly available information that the market was overvaluing or undervaluing the stock are generally implausible.” For example, a fiduciary may (at the market price) invest in a publicly traded solar company or an oil exploration company. Assuming ERISA’s diversification requirements are met and no duty of loyalty issue, either investment is prudent.
… and Thole
We should also note, with respect to DB plans, that the Supreme Court’s decision in Thole v. U.S. Bank holds generally (and oversimplifying somewhat) that where DB participants “have received all of their vested pension benefits … [they] have no concrete stake in this dispute and therefore lack Article III standing” and may not sue. In real life, most of the litigation in this area is likely to be with respect to DC plans.
None of the foregoing says anything about fees. Inevitably, plaintiffs will at some point begin challenging the fees paid with respect to ESG investments. This claim would not be a challenge to ESG investing as such but rather an argument that there is a lower-priced ESG investment available.
We have followed fee litigation for 20 years, and the general lessons from that experience would apply to ESG investments (see for instance our discussion of the Seventh Circuit’s decision on remand in Hughes v. Northwestern).
Very briefly: All of this litigation involves participant directed DC plans. The biggest risk seems to be the use of retail share classes where an institutional share class is available (and, possibly, the use of a higher priced institutional share class where a lower priced one is available). And the courts seem willing to recognize that it is not imprudent to pay higher fees with respect to funds with different (or, arguably, unique) investment objectives. Sponsor fiduciaries selecting ESG funds will want to bear these principles in mind.
The duty of loyalty – DOL’s view
Under DOL’s amended regulation, where alternative investments are “tied,” “collateral benefits [such as ESG “benefits”] other than investment returns” may provide the basis for a fiduciary’s investment decision “if a fiduciary prudently concludes that competing investments equally serve the financial interests of the plan over the appropriate time horizon…. A fiduciary may not, however, accept expected reduced returns or greater risks to secure such additional benefits.”
Of course (as discussed above), where investments are made in an efficient market (e.g., where investments are, directly or indirectly, in publicly traded securities), market pricing means that all investments (in that market) are “tied.”
Thus, in the context of an efficient market, and assuming there is no diversification issue, it should under DOL’s rule be possible to make ESG investments without violating ERISA’s duty of loyalty, so long as they do not involve a prohibited transaction (e.g., they do not involve fiduciary self-dealing). Quoting from the regulation’s preamble: “Finally, while the final rule itself adds no explicit parameters on collateral benefits, ERISA’s prohibited transaction provisions in section 406 remain and generally forbid collateral benefits to the extent any such benefit involves a transaction that violates those provisions.”
Litigation over the application of ERISA’s duty of loyalty to ESG-related litigation is just beginning. Discussion of it in Spence v. American Airlines is perfunctory and does not deal with DOL’s view of the issue.
We would, however, raise two issues with respect to any possible plaintiff’s duty of loyalty claim with respect to an ESG investment. First, where two alternative investments are “tied” – say investment in a (publicly traded) solar power company vs. a (publicly traded) oil exploration company – how do you prove that a fiduciary was motivated by a “collateral interest?” How does a court read the fiduciary’s mind – something courts are typically loathe to do?
And, second, how do you prove damages? The market has decided (presumably, fairly) that these two investments are – given their market-determined prices – financially/economically equivalent.
Both as a separate fiduciary duty (in addition to prudence and loyalty) and as an element of the duty of prudence, an ERISA fiduciary has a duty to “diversif[y] the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.”
The issue of diversification has not (explicitly) come up in ESG litigation thus far. But, as we noted at the top, it is both a separate fiduciary duty and an element of the duty of prudence. Thus, at some point, some plaintiff’s lawyer is likely to raise it. In the absence of explicit rules on the application of the duty to diversify to ESG investing, we make the following observations:
A plan that only provided ESG funds in its fund menu or only invested in ESG or ESG-themed investments could be open to a challenge that it was not adequately diversified.
It is probably the case that the exclusion of a limited number of investment alternatives would not compromise diversification – or at least there would be reasonable differences on this issue among credentialed economists/investment experts.
It is possible that, if such exclusions are significant enough, there would be a consensus that the plan’s assets are not adequately diversified.
Just where the line is between an allowable number of exclusions and “too many” exclusions will ultimately have to be determined by the courts. Sponsors/fiduciaries considering such exclusions will want to consider consulting with their legal adviser and investment consultant before implementing them.
Elaborating on these bullets more generally:
Diversification and DB plans: A good argument can be made that a fiduciary of a DB plan (or a DC plan whose investment portfolio is entirely managed by a fiduciary) should generally only get in trouble when decisions based on “collateral benefits” can be demonstrated to have compromised the plan portfolio’s risk/return value – in effect, that as a result of the ESG investment strategy the plan’s portfolio has been taken “below” the efficient frontier. On a prospective basis. That’s a high bar, and it is likely that, in all but the most obvious cases, experts will differ. (And the obstacles to participant lawsuits against DB plan fiduciaries noted above would apply here as well.)
Diversification and participant directed plans: That bar is even higher in participant-directed DC plans – which is, after all, where most of the litigation will be. In these plans – most would acknowledge – the responsibility of the plan fiduciary is to give the participant the ability to construct an adequately diversified portfolio. But the participant is totally free to construct an inadequately diversified portfolio without causing a fiduciary breach. The existence of “market priced” ESG investment options – where an adequate set of non-ESG options remains available – should not present a problem.
The situation is somewhat different with respect to a qualified default investment alternative (QDIA), such as a default target date fund, where the participant has not made an explicit election. With respect to these funds, principles such as those applicable to DB plans would arguably apply – that is, the fund’s ESG “tilt” should not be so extreme as to present a diversification issue. (We note that the Trump DOL’s prohibition of inclusion of an ESG fund in a QDIA was eliminated in the Biden DOL’s amended regulation.)
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We do not want to overstate the risk here. Clearly the current Administration is favorably disposed towards ESG investing. And – as the above discussion is intended to make clear – plaintiffs will have to clear a relatively high bar to attack ESG investing as a fiduciary breach, especially where an economic/financial justification for it has been provided in committee minutes.
We will continue to follow these issues.