ESG, proxy voting, and ERISA’s revised fiduciary regulation
In our last article, we discussed the highlights of the Department of Labor’s final ESG/Proxy Voting rules, focusing on what changes the 2022 rules make to the 2020 rules. In this article, we review the new rules more generally.
ERISA includes fiduciary duties of prudence and loyalty. DOL has, since 1979, had in place a regulation interpreting those duties generally. Until 2020, however, that regulation did not itself address consideration of environmental, social, and corporate governance (ESG) factors in retirement plan investments – instead, fiduciary issues with respect to ESG investment were addressed in sub-regulatory guidance.
In 2020, the (Trump) DOL did propose and then finalize amendments to the 1979 regulation addressing ESG investments and proxy voting/the exercise of shareholder rights. As discussed in our last article, in 2022, those amendments were then revised by the (Biden) DOL.
What follows is simply a description of the DOL regulation interpreting ERISA’s duties of prudence and loyalty as applied to ESG investments and proxy voting, as revised by these recently adopted amendments to it.
Duty of prudence
Generally, ERISA provides that fiduciary investment decisions must be made “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.”
Under the final regulation, ESG investing is, for purposes of ERISA’s prudence requirement, treated no differently than any other sort of investment. Specifically, in interpreting this statutory provision, the amended regulation provides that fiduciaries must give “appropriate consideration” to relevant facts and circumstances including the role the investment plays in the portfolio/fund menu.
“Appropriate consideration’’ includes:
General prudence. The investment must be reasonably designed as part of the portfolio/fund “to further the purposes of the plan, taking into consideration the risk of loss and the opportunity for gain … compared to … reasonably available alternatives.”
Prudent diversification. For plans other than participant-directed DC plans, the fiduciary must consider: the diversification of the portfolio; portfolio liquidity relative to anticipated cash requirements; and the projected return of the portfolio relative to plan funding objectives.
Based on risk/return factors. The investment decision “must be based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis, using appropriate investment horizons consistent with the plan’s investment objectives and funding policy.” Risk/return factors “may include the economic effects of climate change and other environmental, social, or governance factors …. The weight given to any factor by a fiduciary should appropriately reflect a reasonable assessment of its impact on risk-return.”
Duty of loyalty
Generally, ERISA provides that “a fiduciary shall discharge [its] duties … solely in the interests of the participants and beneficiaries; for the exclusive purpose of providing benefits to participants and their beneficiaries and defraying reasonable expenses of administering the plan.”
Application of this rule to ESG investments is somewhat more complicated (than application of the prudence rule), since it is possible that an investment may be prudent and nevertheless serve a “collateral objective,” that is, an objective of the fiduciary’s unrelated to the plan.
In interpreting this statutory provision, the amended regulation provides that fiduciaries “may not subordinate the interests of the participants … to other objectives, and may not sacrifice investment return or take on additional investment risk to promote benefits or goals unrelated to interests of the participants … in their retirement income or financial benefits.”
Tie-breaker rule. Notwithstanding the foregoing, “collateral benefits other than investment returns” may provide the basis for an 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.”
Duty of loyalty in participant-directed DC plans. In a participant-directed DC plan, the plan fiduciary may take into account participant preferences (e.g., for an ESG fund) so long the investment decision complies with the prudence requirements (above).
Proxy voting/shareholder rights
DOL has for some time taken the position that “[t]he fiduciary duty to manage plan assets that are shares of stock includes the management of shareholder rights appurtenant to those shares, such as the right to vote proxies.” This duty is subject to the duties of prudence and loyalty described above.
In further interpreting this requirement, the regulation provides that:
When deciding whether to exercise shareholder rights/vote a proxy, the fiduciary must consider the cost of doing so, may not “subordinate the interests of the participants and beneficiaries … to any other objective,” must evaluate relevant facts, and must exercise prudence and diligence in selecting and monitoring, e.g., agents to exercise or advise on the exercise of those rights.
The fiduciary may not automatically follow such an advice firm’s recommendations without determining that its guidelines meet regulatory requirements.
The fiduciary may adopt “proxy voting policies providing that the authority to vote a proxy shall be exercised pursuant to specific parameters prudently designed to serve the plan’s interests.” These policies must be periodically reviewed, and appropriate exceptions may be made to them.
Generally, the plan trustee is responsible for exercising shareholder rights, except where it is subject to the directions of a named fiduciary or an investment manager has been appointed. Special rules apply where the investment manager of a pooled vehicle holds assets of more than one (unrelated) plan.
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We will continue to follow this issue.