An ESG Framework Here to Stay?

Art by Scott Bakal

The Department of Labor (DOL) has announced a proposed rule that would remove barriers to plan fiduciaries’ ability to consider climate change and other environmental, social and governance (ESG) factors when they select investments and exercise shareholder rights.

Aptly titled “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” the proposal spans 109 pages, the early consensus being that the rule should facilitate broader use of ESG factors by investors who have long been calling for such an expansion. 

Greater Clarity

John Hoeppner, head of U.S. stewardship and sustainable investments, Legal & General Investment Management America, says he had anticipated that the DOL would provide some clarifying language about the reasonability of ESG-integrated options, but he was “delighted and surprised” to see that the rule specifically calls out the use of ESG factors within investment options serving as a retirement plan’s qualified default investment alternative (QDIA).

“The signaling impact of this decision is enormous, in my opinion,” Hoeppner says, noting that his organization was “quite concerned” about the ESG and proxy voting rules that had been implemented late in the Trump administration. In Hoeppner’s view, those rules were overly restrictive and seemed to be tied to a more antiquated perspective on the purpose and technical aspects of ESG investing.

“In terms of the comment period and the final rule, I expect this package could be slightly modified, but I think the main parts will stick,” Hoeppner says. “Then, the real action happens when the first major corporate defined contribution [DC] plan or the first handful publicly change their default to an ESG option—when you get the likes of a Disney or a Ford moving in this direction. That will be a really big deal that could drive significant momentum toward more universal use of ESG investments within U.S. retirement plans.”

Good Timing

Julie Stapel, a partner in Morgan Lewis’ ESG and sustainability group, notes that the timing of the filing is meaningful. In basic terms, the fact that this proposal has been made relatively early in the Biden administration means it will have much more time to actually be implemented and to gain momentum compared with prior administrations’ efforts to change the rules in this area.

“My first impression is that, if finalized in something like its draft form, it will be very helpful to fiduciaries who have already started to go down this road toward embracing ESG investing,” Stapel says. “I think plan fiduciaries, as represented by the clients we work with, are at many different places along this road, due to a variety of factors, but this proposal will make their journey far easier and more secure.”

Beyond Climate Change

As Sarah Bratton Hughes, global head of sustainability solutions at Schroders, explains, although climate change is mentioned throughout the proposal’s preamble as a major potential risk affecting long-term returns, the DOL is clear that material ESG factors can address much more than just climate change. To this end, it included several examples. Under the heading of “workforce practices,” for example, the agency cites as potentially financially material a corporation’s progress on workforce diversity and its level of investment in fostering positive labor relations. Under governance factors, the DOL says, items such as board compensation and transparency in corporate decisionmaking can be important—as is a corporation’s avoidance of criminal liability and its compliance with labor, employment, environmental, tax and other applicable laws.

Hoeppner, Stapel and Bratton Hughes all say the proposal’s “ESG tiebreaker” language is somewhat important. Currently, collateral ESG factors may be considered only as a tiebreaker where two competing investments are economically indistinguishable. Moreover, the rules as they exist today impose significant documentation provisions, requiring investors to demonstrate that the tiebreaker was used only in that limited context.

The proposed rule, on the other hand, would adopt a more general principle. Under that language, when a fiduciary concludes that two competing investment approaches “equally serve the financial interest of the plan,” the fiduciary could base an investment decision on “economic or noneconomic benefits other than investment returns.”

Bratton Hughes says the Biden DOL seems to think the special documentation requirements from the previous rule create an impression that fiduciaries should be wary of considering ESG factors, even when those factors are financially material to the investment decision.

Potential Changes

A team of attorneys with The Wagner Law Group said in their interpretation of the proposal that the details will be scrutinized by different concerned parties in the coming months and noted that public comments are due by December 13.

“Unlike the 2020 rule, this proposed revision of the investment duties rule arguably creates more room for the neutral exercise of fiduciary discretion with fewer regulatory constraints,” the attorneys write. “Thus, it is likely not to generate a wave of opposition as its predecessor did.”