DOL Issues Final ESG Rule, Allowing Latitude for Fiduciaries to Consider Environmental, Social, and Governance (ESG) Factors

On November 22, 2022, the U.S. Department of Labor (“DOL”) issued its much anticipated and long-awaited final rule regarding the consideration of environmental, social, and governance (“ESG”) along with climate change factors in investment selection and proxy voting by ERISA-covered retirement plan fiduciaries (the “Final ESG Rule”).¹ The DOL’s Final ESG Rule represents a shift away from two regulations² issued in 2020 during the Trump administration, which required that plan fiduciaries consider only “pecuniary” factors in investment decisions (the “2020 Regulation”).³   

While the DOL’s Final ESG Rule removes obstacles erected by the 2020 Regulation to fiduciaries’ consideration of ESG investment options for 401(k) plans, the final rule actually adopts a middle of the road approach by returning discretion to fiduciaries. Importantly, as the DOL repeatedly emphasized, the Final ESG Rule does not alter ERISA’s bedrock principle that plan fiduciaries’ decisions must be based on factors that are relevant to the likely risk and return of an investment and gives fiduciaries latitude only to consider the economic effects of ESG factors on the risk and return of a particular investment.

The Final ESG Rule supersedes the 2020 Regulation and Interpretive Bulletin 2015-01 (along with related 2015 Field Assistance Bulletins), which had suggested that ESG factors might be applied only narrowly in “tie-breaker” circumstances in favor of two potential investments that were “indistinguishable” from a pecuniary perspective, but only one of which would have collateral ESG benefits.⁴

The Key Changes in the 2022 Final ESG Rule

The Final ESG Rule contains five key elements:

• The Final ESG Rule Removes Barriers to Consideration of ESG Factors as Part of a Risk Return Analysis: First, the Final ESG Rule eliminates the distinction between “pecuniary” and “non-pecuniary” factors set forth in the earlier regulations and, instead, provides that a fiduciary “may” consider any factor material to an investment’s risk or return, including climate change and other ESG factors.⁵ In other words, as the DOL observed, “a fiduciary may reasonably conclude that climate-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, can be relevant to a risk/return analysis of an investment or investment course of action.”⁶ The DOL nevertheless took great pains to repeatedly emphasize that “ERISA plan fiduciaries [must] focus on relevant risk-return factors and not subordinate the interests of participants and beneficiaries (such as by sacrificing investment returns or taking on additional investment risk) to objectives unrelated to the provision of benefits under the plan.”⁷ In this respect, the Final Rule dovetails with the position taken by 15 Attorneys General that ESG factors should be used “to evaluate Value—the risk and reward of a potential investment—not Values—a subjective preference as to whether a given business or entity merits investment based on the nature of its business.”⁸ 
• The Final ESG Rule Rescinds the Prohibition on ESG Investments Serving as QDIAs: Second, the Final ESG Rule rescinded the 2020 Regulation’s prohibition on a plan’s qualified default investment alternative (“QDIA”) considering ESG factors and instead applies the same standard to QDIAs as other investments.  
• The Final ESG Rule Revises the “Tie-breaker” Test: Third, the Final ESG Rule also eliminated the 2020 Regulation’s limitation that “collateral non-financial factors” could only be considered as a “tie-breaker” if two competing investments were “economically indistinguishable” based on pecuniary factors. The Final ESG Rule instead provides that a fiduciary may consider collateral benefits other than investment returns if the fiduciary concludes that “competing investments, or competing investment courses of action, equally serve the financial interests of the plan over the appropriate time horizon.”⁹ In addition, the Final ESG Rule eliminates many of the more onerous documentation requirements for selecting ESG investments.
• The Final ESG Rule Encourages Consideration of Participants’ Preferences: Fourth, the Final Rule provides additional leeway for fiduciaries to consider, including ESG options in a 401(k) plan’s investment lineup by noting that a fiduciary of a defined contribution plan does not violate the duty of loyalty by taking into account participants’ preferences.¹⁰ As the DOL noted, however, this clarification “does not speak to the duty of prudence” and plan fiduciaries must still engage in a prudent process to analyze the risk and return characteristics of an investment without regard to participants’ desires.¹¹   
• The Final ESG Rule Eliminates Heightened Scrutiny of ESG-Related Proxy Votes: Finally, the Final ESG Rule eliminates burdensome recordkeeping requirements and language in the 2020 Regulation that a fiduciary’s duties “does not require the voting of every proxy or the exercise of every shareholder right” because the DOL concluded that it “may be misread as suggesting that plan fiduciaries should be indifferent to the exercise of their rights as shareholders.”¹² In making these changes, the DOL emphasized that it believes that shareholder rights can enhance and protect plan assets.¹³

Key Takeaways:

While the Final ESG Rule certainly expands the ability of ERISA fiduciaries to consider ESG factors, the Final ESG Rule does not “put a thumb on the scale in favor of ESG factors,” nor does it go as far as some commentators urged by, for example, including a “safe harbor” for ESG investments.¹⁴ In rescinding the 2020 Regulation, the DOL simply eliminated any distinct treatment of ESG investments and restored discretion to fiduciaries to evaluate ESG factors alongside other factors in vetting investment alternatives. While some fiduciaries may interpret the Final ESG Rule as an invitation to increasingly begin offering ESG investments,¹⁵ other fiduciaries may act more cautiously considering the proliferation of defined contribution class action ERISA litigation in recent years.  The Final ESG Rule does not eliminate or meaningfully reduce the litigation risk faced by defined contribution plan fiduciaries who could be exposed to potential claims if they select ESG investment options that underperform and cost more than non-ESG peers with similar strategies and asset-class exposures.¹⁶

Another reason fiduciaries may hesitate before making available ESG alternatives is the possibility that the regulatory pendulum will swing once again if a new administration takes office in 2025.  Needless to say, the consideration of ESG factors by asset managers has already generated significant controversy. For example, on August 4, 2022, 19 Attorneys General sent a letter to the CEO of BlackRock accusing Blackrock of breaching its duties of loyalty and prudence in managing state pension funds by considering ESG factors.¹⁷ Both the Louisiana Attorney-General and the Indiana Attorney-General have likewise issued legal guidance that the consideration of ESG factors by investment firms likely would, under certain circumstances, violate the fiduciary duty owed by these investment firms to their investors.¹⁸ Moreover, more than a dozen Republican state legislatures have passed or proposed bills that blacklist ESG-friendly money managers or ban ESG investing altogether (whereas an equal number of Democratic state legislatures have implemented or are considering legislation that encourages the consideration of ESG factors).¹⁹ These developments at the state level deepen the divergence between state and federal regulators and portend potential heightened litigation risk for fiduciaries and asset managers together.

¹Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights, 87 FR 73822 (December 1, 2022) (“Final ESG Rule”), available at https://www.federalregister.gov/documents/2022/12/01/2022-25783/prudence-and-loyalty-in-selecting-plan-investments-and-exercising-shareholder-rights.

² Financial Factors in Selecting Plan Investments, 85 Fed. Reg. 72846 (Nov. 13, 2020), available at https://www.govinfo.gov/content/pkg/FR-2020-11-13/pdf/202024515.pdf; Fiduciary Duties Regarding Proxy Voting and Shareholder Rights, 85 Fed. Reg. 81658 (Dec. 16, 2020), available at https://www.federalregister.gov/documents/2020/12/16/2020-27465/fiduciary-dutiesregarding-proxy-voting-and-shareholder-rights.

³In rescinding the 2020 Regulation, the DOL concluded that those regulations had “created uncertainty” and caused “a chilling effect and other potential negative consequences” by discouraging ERISA fiduciaries from “consideration of climate change and other ESG factors in investment decisions, even in cases where it is in the financial interest of plans to take such considerations into account.”  See DOL’s Final ESG Rule, 87 FR at 73826; see also DOL Press Release, U.S. Department of Labor Announces Final Rule to Remove Barriers to Considering Environmental, Social, Governance Factors in Plan Investments (November 22, 2022) (“‘The rule announced today will make workers’ retirement savings and pensions more resilient by removing needless barriers, and ending the chilling effect created by the prior administration on considering environmental, social and governance factors in investments,’ said Assistant Secretary for Employee Benefits Security Lisa M. Gomez.  ‘Climate change and other environmental, social and governance factors can be useful for plan investors as they make decisions about how to best grow and protect the retirement savings of America’s workers.’”), available at https://www.dol.gov/newsroom/releases/ebsa/ebsa20221122.

⁴The Final ESG Rule becomes effective on January 30, 2023.

⁵Notably, the Final 2022 ESG Rule departs from the rule that the DOL proposed in October 2021 by eliminating language suggesting that consideration of the projected return of an investment “may often require an evaluation of the economic effects of climate change and other environmental, social or governance factors . . . .”  Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights, 86 Fed. Reg. 57272, 57276 (Oct. 14, 2021), available at https://www.federalregister.gov/documents/2021/10/14/2021-22263/prudence-andloyalty-in-selecting-plan-investments-and-exercising-shareholder-rights. The DOL explained that it had eliminated this language in response to critiques from commentators because the DOL did not want to be perceived as having created “an overarching regulatory bias in favor of ESG strategies” or implying that such factors are relevant in all cases.  DOL’s Final 2022 ESG Rule, 87 FR at 73831.

⁶DOL’s Final 2022 ESG Rule, 87 FR at 73831.

⁷87 FR at 73827.

⁸Ltr. From Fifteen Attorneys General to Senators Brown and Toomey and Representatives Waters and McHenry (Nov. 21, 2022), available at https://ag.ny.gov/sites/default/files/esg_letter_final.pdf.

⁹87 FR at 73827.

¹⁰The preamble cites research suggesting that accommodating participant preferences will lead to greater participation and higher deferral rates.  See 87 FR at 73828.

¹¹87 FR at 73828.

¹²87 FR at 73828.

¹³87 FR at 73828.

¹⁴87 FR at 73831.

¹⁵For example, Bryan McGannon, Managing Director of U.S. SIF, the Forum for Sustainable and Responsible Investment, predicted that “In the next few years, more and more plans will be offering sustainable options as a result of this rule.”  See Mark Schoeff Jr., DOL’s Final ESG Rule Puts an End to Trump Administration Restrictions, Investment News (Nov. 22, 2022), available at https://www.investmentnews.com/dols-final-esg-rule-puts-an-end-to-trump-administration-restrictions-229519.

¹⁶ESG funds are typically actively managed funds, which have a higher expense ratio than passive index funds available on the market.  See e.g., Rob Berger and Benjamin Curry, The Best ESG Funds of 2021, Forbes Advisor (Nov. 1, 2021), available at https://www.forbes.com/advisor/investing/best-esg-funds/. This type of claim would be similar to the mushrooming claims brought in the last few years against defined contribution plan fiduciaries alleging fiduciary breaches based simply on the plan’s inclusion of actively managed funds that were more expensive than passive alternatives, and that those funds underperformed the passive alternatives over relatively short periods.

¹⁷See Ltr. from Nineteen Attorneys General to Laurence D. Fink, CEO, BlackRock, Inc. (Aug. 4, 2022), https://www.texasattorneygeneral.gov/sites/default/files/images/executive-management/BlackRock%20Letter.pdf; see also SEC.gov, Comments on Environmental, Social, and Governance Disclosures for Investment Advisers and Investment Companies, https://www.sec.gov/comments/s7-17-22/s71722.htm; SEC.gov, Comments for the Enhancement and Standardization of Climate-Related Disclosures for Investors, https://www.sec.gov/comments/s7-10-22/s71022.htm; see also Public, Private Pensions Set to Collide over ESG Investing, Bloomberg Law (Oct. 12, 2022), available at https://news.bloomberglaw.com/daily-labor-report/public-private-pensions-on-collision-path-over-esg-investing.

¹⁸ Louisiana and Indiana Attorneys-General Issue Guidance That Investment Firms Incorporating ESG Factors Violate Their Fiduciary Duty, National Law Review (Sept. 15, 2022), available at https://www.natlawreview.com/article/louisiana-and-indiana-attorneys-general-issue-guidance-investment-firms.

¹⁹Public, Private Pensions on Collision Path Over ESG Investing, Bloomberg Law (Oct. 12, 2022).

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