On October 13, the Department of Labor (DOL) issued a proposed rule on environmental, social, and governance (ESG) investing and on proxy voting entitled “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights.”

Background

The proposed rule is in direct response to two rules from the Trump administration (“Financial Factors in Selecting Plan Investments” published in November 2020, colloquially known as the ESG rule, and “Fiduciary Duties Regarding Proxy Voting Shareholder Rights” published in December 2020). As Callan highlighted in March, the DOL under the Biden administration announced it would not be enforcing these rules, noting the “chilling effect” they had on ESG integration. In May, the White House issued a multipart executive order on climate-related financial risk that stated the DOL would consider publishing a proposed rule later in the year to “suspend, revise, or rescind” the Trump administration ESG and proxy voting rules.

The proposed rule covers the two separate issues addressed in the two prior rules: ESG integration and proxy voting by ERISA fiduciaries.

Regarding ESG integration:

• The proposed rule reminds ERISA fiduciaries of their duties of loyalty to plan participants and beneficiaries, and of prudence in exercising their fiduciary responsibilities.
• The proposed rule highlights that an investment evaluation “may often require” considering climate change and other ESG factors. But it does not say ESG evaluation is always required, which was a topic of speculation leading up to the publishing of this proposed rule.
• The proposed rule attempts to remove the barrier between categorization of traditional and non-traditional investment factors, such as ESG factors, by noting that a prudent fiduciary may consider any factor that is deemed material to the risk-return analysis. The paragraph notes that material ESG factors are not different than other risk/return factors and thus fiduciaries have a duty to consider them when evaluating an investment. It further states that climate change is “particularly pertinent to the projected returns of pension plan portfolios that, because of the nature of their obligations to their participants and beneficiaries, typically have long-term investment horizons.”
• The proposed rule includes example of environmental, governance, and workforce factors that could impact investments:
  • “Climate change-related factors, such as a corporation’s exposure to the real and potential economic effects of climate change including exposure to the physical and transitional risks of climate change and the positive or negative effect of Government regulations and policies to mitigate climate change;
  • Governance factors, such as those involving board composition, executive compensation, and transparency and accountability in corporate decision-making, as well as a corporation’s avoidance of criminal liability and compliance with labor, employment, environmental, tax, and other applicable laws and regulations; and
  • Workforce practices, including the corporation’s progress on workforce diversity, inclusion, and other drivers of employee hiring, promotion, and retention; its investment in training to develop its workforce’s skill; equal employment opportunity; and labor relations.” 
• The proposed rule also addresses the so-called “tiebreaker rule,” whereby for otherwise similar investments, other factors can be considered in selection to break the tie. The proposed rule states that investments which “equally serve the financial interests of the plan” can be differentiated by the “collateral benefits” (non-financial benefits) they provide. The preamble suggests that using the broad language of equally serving the financial interests of the plan was intentional to give fiduciaries more latitude, understanding that no two proposed investments are indistinguishable in every way. This move away from the categorization of indistinguishable investments is a departure from the prior rule, and the increased documentation requirements that existed are also removed.
• The proposed rule addresses ESG integration in defined contribution plans and investment options they offer, including the qualified default investment alternative (QDIA), noting that the collateral benefits of any fund must be “prominently displayed in disclosure materials provided to participants and beneficiaries,” and reminding fiduciaries that they cannot accept reduced returns or increased risk in the name of trying to achieve these collateral benefits. This is a significant change from the prior rule, which did not allow QDIAs to consider “non-pecuniary” (non-financial) factors.

For proxy voting:

• Like the ESG section, the proxy voting section states that fiduciaries must exercise their shareholder rights prudently and for the benefit of participants and beneficiaries; these duties cannot be “subordinated” to other causes.
• The proposed rule notes that ERISA fiduciaries must exercise prudence and diligence in the selection and monitoring of proxy voting vendors, such as firms that provide proxy voting recommendations.
• ERISA fiduciaries must only select firms that provide proxy advisory services consistent with the fiduciary duties outlined in the proposed rule.
• The proposed rule notes that ERISA fiduciaries should periodically review their proxy voting policies.
• As stated in the preamble, this proposed rule intends not to dissuade fiduciaries from voting proxies when the topic is one that could financially impact the plan’s investment, nor to dissuade fiduciaries from not voting when there is no material financial impact to the plan.
• The proposed rule differentiates between when plans vote their own proxies from when that duty is delegated to investment managers. The proposed rule states that investment managers should vote proxies in proportion to each plan’s economic interest in a pooled vehicle, if there is a conflict between plan proxy voting policies. The proposed rule does note an alternative, in which an investment manager has a proxy voting policy that participating plans are required to accept prior to investing in the vehicle. The proposed rule then puts the onus on ERISA fiduciaries to assess the proxy voting policy for ERISA compliance prior to investing.
• Compared to the prior rule, the proposed rule removes language about fiduciaries not being required to vote proxies, two proxy-voting “safe harbor” policies, and the documentation and monitoring burdens of the prior rule.

Bottom Line: It is clear from both the preamble and the proposed rule itself that this rule is more favorable for both ESG integration and plan sponsors’ exercising shareholder rights than Trump administration rules it would replace. The proposed rule has a 60-day comment period, after which the DOL is expected to consider public comments and then publish a final rule. Plan sponsors are encouraged to review the proposed rule and the preamble with their legal counsel. Callan will continue monitoring these regulatory developments for our clients.  

Read the preamble and proposed rule here.