On June 23, 2020, the U.S. Department of Labor issued a proposal to regulate the use of environmental, social, and governance (ESG) strategies by investment fiduciaries under ERISA.[1] The proposal, if finalized, would be the first rulemaking since ERISA was passed in 1974 in which the Department has singled out a specific strategy for more rigorous treatment under ERISA’s duties of loyalty and prudence.
The proposal’s stated goals are to ensure that retirement assets are maximized and not “enlisted in pursuit of other social or environmental objectives.” The effect of the proposal, if finalized as is, would likely suppress investment by ERISA plans in ESG strategies, without regard to their ability to help maximize retirement assets.[2] Perhaps unintentionally, the proposal could also adversely impact investment in actively managed strategies and closed-architecture individual account plan menus, due to the breadth of its language.
Since 1994, the Department has addressed ESG strategies through non-binding sub-regulatory guidance.[3] While all such guidance was premised on the principal that non-pecuniary ESG considerations cannot justify an investment that is less attractive from a risk/return perspective, the tenor of that guidance has shifted over time, swinging between favorable and cautionary positions depending on administration. The current administration issued its cautionary guidance in 2018.[4] It now seeks to memorialize its position and inhibit future shifts to more favorable stances through regulatory action. It also appears to have made ESG a current enforcement priority notwithstanding that its proposal remains pending.[5]
While the proposal expressly addresses perceived risks associated with the consideration of ESG factors, the proposal does not give significant attention to relevant data. For example, the proposal does not address the data reflected in the 2018 United States General Accounting Office (GAO) report on ESG investing, which states that the vast majority of peer-reviewed academic studies reviewed by the GAO found, in almost all cases considered, a neutral or positive correlation between the consideration of ESG factors and investment returns. The proposal also does not address similar data in a 2017 study on ESG investing commissioned by the Department of Labor itself.[6] Instead, the proposal appears to merely assume that the consideration of ESG factors generally will have the opposite effect.
Addressing the economics of ESG strategies, the proposal suggests that they are suspect because they have higher fees than passively managed index funds.[7] In a similar vein, the proposal states the Department’s hope that, once finalized, the regulation will cause plans to shift away from actively managed funds to lower-cost or passively managed index funds.[8] These are remarkable positions, given that the Department has never opined that fiduciaries must always select the cheapest investment available. Indeed, just earlier this month, the Department confirmed that individual account plans may offer options with actively managed private equity components even though they “tend to involve more complex organizational structures and investment strategies, longer time horizons, and more complex, and typically, higher fees.”[9]
The proposal’s treatment of ESG strategies departs from its prior treatment of both ESG and other strategies. Five years ago, the Department explained in the context of ESG investments: “Fiduciaries need not treat commercially reasonable investments as inherently suspect or in need of special scrutiny merely because they take into consideration environmental, social, or other such factors.”[10] Earlier this month, the Department affirmed this same general approach in the context of private equity.[11] In the 1980s, the Department took a similar view of investing in derivatives.[12]
The Department explains that regulation is now needed because of the growth in ESG investing and the marketing of ESG options.[13] It is unclear why this is so. In the proposal, the Department states its belief that few fiduciaries are violating the law in connection with ESG strategies.[14] Further, ERISA already requires fiduciaries to possess (or hire) the sophistication necessary to prudently consider investment alternatives — ESG or otherwise — regardless of how they are marketed and, to the extent they fail to do so, ERISA provides for expansive liability and other remedies.[15]
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