DOL's ESG rule running into political headwinds

Efforts in Congress and in federal courts to overturn the Department of Labor's new rule permitting retirement plan fiduciaries to consider climate change and other ESG factors when selecting investments and exercising shareholder rights are driven more by politics than substance, industry experts said, but the consolidated opposition and the regulatory uncertainty it brings may give plan sponsors pause.

"There's a larger political issue that's being fought and the first front in this battle is the DOL rule when the rule itself is actually not doing most of the things that the battle's about," said Bradford P. Campbell, a Washington-based partner at law firm Faegre Drinker Biddle & Reath LLP and former assistant secretary of labor for the Employee Benefits Security Administration during President George W. Bush's administration.

The new rule — Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights — took effect Jan. 30 and allows ERISA fiduciaries to consider environmental, social and governance factors. It also maintains the department's position that fiduciaries may not sacrifice investment returns or assume greater investment risks as a means of promoting collateral social policy goals.

The rule is a reversal of two rules promulgated late in the Trump administration that said retirement plan fiduciaries could not invest in "non-pecuniary" vehicles that sacrifice investment returns or take on additional risk and outlined a process a fiduciary must undertake when making decisions about casting a proxy vote.

One day after the House in a 216-204 vote approved a joint resolution under the Congressional Review Act to nullify the rule, the Senate on March 1 followed suit, passing the resolution in a 50-46 vote with backing from two Democratic senators, Joe Manchin of West Virginia and Jon Tester of Montana.

Sen. Mike Braun, R-Ind., who introduced the resolution in February, said at a March 1 press conference that the Labor Department rule jeopardizes retirement savings for millions of Americans for a political agenda. "This is our way to say, 'Enough is enough,'" Mr. Braun said.

House Speaker Kevin McCarthy, R-Calif., sent the resolution to President Joe Biden on March 9. Mr. Biden has promised to veto it, which will mark the first veto of his administration, but had not done so as of press time.

Industry stakeholders, ERISA attorneys and Labor Department officials mostly characterize the new rule as neutral.

"The purpose of that rule is to just make it clear that fiduciaries can take ESG factors into consideration when they're making retirement decisions, just like they would prudently consider any other factors," said Lisa M. Gomez, assistant secretary of labor for the Employee Benefits Security Administration, on Feb. 28 at a National Institute on Retirement Security conference.

The rule has "become the focal point onto which is being projected a much larger debate and that debate I think is misplaced when it applies to this actual rule," Mr. Campbell said, referencing the rule's neutrality. "There really is a bigger picture dispute here over what is the role of social activism in capital markets."

Republicans in Congress and in states across the country have pushed back heavily against Biden administration regulations pertaining to climate change and ESG investing. Notably, a proposed rule from the Securities and Exchange Commission to require public companies to disclose a host of climate-related information in their registration statements and periodic reports has drawn criticism from Republicans, but has broad support from institutional investors and asset managers.

The actions in Congress as well as two lawsuits filed recently in federal court to undo the rule may lead to some plan sponsors pausing "any movement in adding an ESG fund to the investment lineup," said Will Hansen, Arlington, Va.-based executive director of the Plan Sponsor Council of America and chief government affairs officer at the American Retirement Association. But ultimately, "plan sponsors will follow a prudent process in selecting an investment fund for the retirement plan, which means they will undergo a process of selecting quality funds that are best for their specific employee population."

Elizabeth S. Goldberg, a Pittsburgh-based partner with Morgan, Lewis & Bockius LLP, said that many of her firm's clients are evaluating "how they can balance satisfying a public interest in ESG investing, maintaining their fiduciary duty and navigating a climate where ESG is under attack. It's not stopping ERISA plans (from) considering ESG, but forcing fiduciaries to be intentional and careful in how they consider the guidance."

Bryan McGannon, Washington-based acting CEO and managing director at US SIF: The Forum for Sustainable and Responsible Investment, a non-profit organization whose members represent $5 trillion in assets under management, said the rule has been "swept up into a political mess."

He added, "This is sound, sensible policy not mandating anything. It's a convenient political tool for one party to use on their attacks on a broad set of issues."

Even with Mr. Biden's veto, the Labor Department rule is still facing challenges on the legal side.

Republican attorneys general from 25 states, led by Ken Paxton of Texas and Sean D. Reyes of Utah, filed a lawsuit in January in U.S. District Court in Amarillo, Texas, arguing that the rule undermines key protections for retirement savers, oversteps the department's authority under ERISA and is arbitrary and capricious.

In their lawsuit, the attorneys general said the Labor Department "does not adequately justify its decision to permit fiduciaries to consider non-pecuniary factors when making investment decisions or exercising shareholder rights. By formally injecting ESG concepts into the ERISA prudent duty regulations, DOL has ventured into territory that Congress explicitly rejected when it drafted ERISA."

A lawsuit with similar arguments was filed last month in U.S. District Court in Milwaukee by two 401(k) plan participants.

George Sepsakos, a Washington-based principal at Groom Law Group, said that while the new rule is neutral, it's impossible to know how a court will decide in either case.

"It just adds more uncertainty to the process, and I think fiduciaries don't love uncertainty when they're making investment decisions," Mr. Sepsakos said.

Also, since the start of the 2023 legislative session, 26 states have proposed their own versions of ESG investing regulations, 23 of which seek to limit or restrict the consideration of ESG factors by state funds and/or their fiduciaries, Ms. Goldberg said, citing a Morgan Lewis tally. "ERISA pre-empts these state laws as they would apply to private employer-sponsored retirement plans, but these state regulations serve as proverbial 'canaries in the coal mine' indicating what future ESG regulation may look like at the federal level if there is a shift in control of the Senate and the White House," Ms. Goldberg added.

With that in mind, it is important for fiduciaries to carefully consider the role that ESG considerations play in their investment decisions, she said.

"Neither the (Congressional Review Act) resolution, nor the federal lawsuits, nor the state level activity would result in outright bans on consideration of ESG factors in investing, writ large," she said. "Their ultimate focus is on limiting the reasons why fiduciaries and companies may consider certain ESG factors."

US SIF's Mr. McGannon is pushing for a legislative solution in Congress to codify the rule into law.

In February, Democrats in the House and Senate introduced a bill to do just that, but the bill is unlikely to move this session as a majority of lawmakers just voted to nullify the rule.