On November 22, 2022, the U.S. Department of Labor (the “DOL”) published a regulation entitled “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights” (the “Final Rule”). The Final Rule follows proposed rules regarding ESG investing and proxy voting by plan fiduciaries, issued on October 14, 2021 (the “Proposed Rule”) and amends prior regulations on the same topic issued by the DOL under President Trump in 2020 (the “2020 Rule”).
In the Final Rule, the DOL repeatedly emphasized that the regulation was primarily aimed at removing and remedying the chilling effect on ESG investing by plan fiduciaries created by the 2020 Rule. While the Final Rule takes a more permissive stance on the consideration of climate change and other ESG factors in investment decisions by plan fiduciaries than the 2020 Rule, the DOL cautioned that a plan fiduciary should not subordinate the interests of plan participants and beneficiaries to any collateral benefits (i.e., ESG objectives).
The Final Rule largely tracks the Proposed Rule, with a few notable exceptions summarized below.
Examples of ESG factors that may be relevant to the risk-return analysis
In the preamble to the Final Rule, the DOL explained that the risk-return analysis should be paramount in making investment decisions but highlighted that ESG factors may be relevant to such analysis. The Proposed Rule underscored this principal and stated that when evaluating an investment or investment course of action, a prudent fiduciary may consider any factor which is material to the risk-return analysis and included specific examples that may be relevant, including climate change related factors, governance factors and workforce practices including diversity and inclusion initiatives.
Several commentators noted that the list of examples of ESG factors that may be relevant to a risk-return analysis could be viewed as a mandate that a prudent plan fiduciary must consider the economic effects of climate change and other ESG factors. The DOL was ultimately persuaded that repeated mention of specific ESG factors in the Proposed Rule may be heavy-handed and struck the examples from the Final Rule. In doing so, the DOL clarified that the examples were only intended to illustrate that ESG factors may be financially material to an investment decision.
Disclosure of ESG factors in a tiebreaker scenario
The 2020 Rule restricted the use of collateral ESG factors to scenarios where two investment options or courses of action are “indistinguishable” based on pecuniary factors alone and the fiduciary maintains documentation of the use of ESG factors as a “tiebreaker.”
The Proposed Rule replaced the “tiebreaker” standard of the 2020 Rule and removed the documentation requirement. The Proposed Rule allowed ESG factors to be used in selecting between two investment options or courses of action that “equally serve the financial interests of the plan over the appropriate time horizon.” This language was also adopted in the Final Rule. However, the Proposed Rule required that if ESG factors were considered in selecting a designated investment options, then the “collateral benefit characteristic” of the investment must be “prominently displayed in disclosure materials provided to plan participants and beneficiaries.” The DOL articulated that its rationale for including the disclosure requirement was to alert plan participants who may not share the same preference for the non-economic factor to be aware of the nature of the investment.
Commentators overwhelmingly voiced their objection to the disclosure requirement in the Proposed Rule, stating that it was unclear what “collateral benefit characteristics” a fiduciary would be required to disclose and that the collateral purpose that tipped the scale is not necessary to whether the investment option is economically prudent and makes economic sense to a participant. In addition, many commentators pointed out that there are already existing regulations that detail what information must be disclosed to plan participants in order for such participants to make an investment decision and that highlighted disclosure of ESG factors could create a chilling effect on the use of such factors.
Based on the concerns raised by commentators, the Final Rule removed the additional disclosure requirement for designated investment alternatives in participant-directed plans. However, the DOL left open the door to revisit the need for disclosure requirements.
Incorporation of participant preferences in crafting an investment menu
The Final Rule permits a plan fiduciary, in selecting the investment line-up for a participant-directed defined contribution plans (such as 401(k) plans), to consider participants’ policy, social or other non-financial preferences. In response to certain commentators who argued that under previous guidance, it was ambiguous whether fiduciaries could consider participants non-economic preferences, the DOL clarified its position that such consideration does not violate the duty of loyalty. Commentators asserted that taking into account the preferences of participants would increase participation and increase deferral rates. In the preamble, the DOL seemingly agreed with these commentators, but cautioned that fiduciaries may not select imprudent investment options solely to accommodate participants’ preferences.
The Final Rule does not propose a method by which a plan fiduciary would ascertain any non-financial preferences of the participants.
Fiduciary duty to evaluate the exercise of shareholders’ rights
The Final Rule maintains, consistent with the Proposed Rule, that a fiduciary’s duties extend to the decision to exercise shareholders rights, such as proxy voting. Some commentators felt that the 2020 Rule suggested that fiduciaries needed to provide special justification in order to participate in proxy voting. In response, the DOL articulated it’s view that proxies should be voted unless a fiduciary determines that exercising the proxy vote would not be in the best interest of the plan (e.g., due to the prohibitive cost).
The substance of the Final Rule is nearly identical to the Proposed Rule, which is summarized here.