Comment on the Proposed DOL Rule

Max M. Schanzenbach is the Seigle Family Professor of Law at the Northwestern University Pritzker School of Law and Robert H. Sitkoff is the John L. Gray Professor of Law at Harvard Law School. This post is based on their comment letter to the U.S. Department of Labor. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here) and Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Robert H. Sitkoff and Max M. Schanzenbach (discussed on the Forum here).

We are writing in response to the above referenced proposed rulemaking by the Department of Labor (the “Department”) on financial factors in selecting plan investments (the “Proposal”), in particular environmental, social, and governance factors (“ESG”).

This response is based on our expertise in ESG investing, especially ESG investing by trustees and other fiduciaries. We have undertaken several years of scholarly study of ESG investing by fiduciaries, and recently published our conclusions in “Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee,” 72 Stanford Law Review 381 (2020) (“ESG Investing by a Trustee”) (discussed on the Forum here). In a consulting capacity for Federated Hermes, Inc., moreover, we have prepared several white papers and videos and conducted training sessions on ESG investing for trustees and other fiduciary investors.

Introduction

In general, we are supportive of the Proposal’s central purpose of subjecting ESG investing to the same fiduciary principles of loyalty and prudence that are applicable to any type or kind of investment. For the reasons elaborated in ESG Investing by a Trustee, doing so is consistent with the fiduciary principles codified by the Employee Retirement Income Security Act (“ERISA”), with the case law interpreting ERISA, and with the background common law of trusts.

We do, however, have some criticisms of the Proposal. Our aim is to offer these criticisms constructively to assist the Department in revising the Proposal toward a final rule. The thematic point that underpins most of our comments is that the law neither favors nor disfavors ESG investing. Any investment decision by an ERISA trustee or other fiduciary—whether in the context of a direct investment, shareholder engagement (including proxy voting), or menu construction, and whether reliant on ESG factors or otherwise—is subject to the same fiduciary principles embodied in the duties of loyalty and prudence.

As interpreted by the Supreme Court, the ERISA fiduciary duty of loyalty requires a trustee or other fiduciary to be motivated solely by providing financial benefits to the plan participants. The ERISA fiduciary duty of prudence as applied to investment matters is elaborated by the prudent investor rule and, as interpreted by the Supreme Court, aligns with ordinary trust law. The prudent investor rule requires the trustee or other fiduciary to assess risk and return, diversification, and costs while documenting its decisions and undertaking ongoing monitoring thereafter, making adjustments to the investment program as circumstances require. The statute requires neutral application of these principles of loyalty and prudence to all investment decisions, whether ESG or otherwise. Indeed, one of the key advances of the prudent investor rule was eschewing presumptions for or against any particular type or kind of investment strategy or vehicle. Neutral application of fiduciary principles also avoids the morass of defining with precision what activities fall within and without the rubric of ESG investing.

We believe that the Department agrees that background law subjects all types or kinds of investment strategies or vehicles, whether ESG or otherwise, to the same principles of loyalty and prudence. In the words of the Proposal:

The duty of loyalty—a bedrock principle of ERISA, with deep roots in the common law of trusts requires those serving as fiduciaries to act with a single-minded focus on the interests of beneficiaries. And the duty of prudence prevents a fiduciary from choosing an investment alternative that is financially less beneficial than an available alternative. These fiduciary standards are the same no matter the investment vehicle or category.

Nevertheless, in certain respects the Proposal departs from the foregoing principle of neutrality that “fiduciary standards are the same no matter the investment vehicle or category.” Our chief criticisms, which may be summarized as falling into two categories, generally reflect instances in which the Proposal differentiates or could be construed as differentiating ESG investing from other types or kinds of investment strategies:

  • First, the Proposal and accompanying commentary could be read to suggest that all manner of ESG investing is inherently suspect, presumably on fiduciary loyalty grounds, and therefore that ESG investing by an ERISA trustee or other fiduciary is always subject to enhanced scrutiny that requires extra process relative to other types of kinds of investment strategies. Such a position is inconsistent with law and sound policy. Use of ESG factors in pursuit of enhanced risk-adjusted returns (what we call “risk-return ESG”) does not categorically trigger a loyalty concern. And the rigor of the duty of prudence applies equally to all modes of investing, whether ESG or otherwise. Departure from neutral application of fiduciary principles also requires drawing distinctions between ESG investing and other investing, a definitional morass that would create uncertainty and invite litigation.
  • Second, portions of the commentary are unclear or phrased in a manner that could be construed as taking positions, such as with respect to active versus passive investing, that are not consistent with neutral application of the principles of fiduciary investment law. The commentary is also notable for not addressing certain other relevant matters, such as the use of ESG factors in shareholder engagement (sometimes called “stewardship” or “active shareholding”). We identify material instances of such language or omissions and urge appropriate clarification, including to the “tiebreaker” rule for purportedly identical investments.

Finally, anticipating that some commentators may urge the Department to mandate ESG investing, we draw the Department’s attention to the more extensive analysis of that issue in ESG Investing by a Trustee, in which we conclude that such a mandate would be contrary to law and sound policy.

“Risk-Return” versus “Collateral Benefits” ESG

“ESG investing” resists precise definition. Roughly speaking, it is an umbrella term that refers to an investment strategy that emphasizes a firm’s governance structure or the environmental or social impacts of the firm’s products or practices.

The original motives for ESG investing were moral or ethical, based on third-party effects rather than investment returns (earlier called “socially responsible investing” or “SRI”). More recently, some have asserted that ESG investing could improve risk-adjusted returns, thereby providing a direct benefit to investors. For example, instead of avoiding the fossil fuel industry to achieve collateral benefits from reduced pollution, ESG proponents argued that the fossil fuel industry should be avoided because financial markets underestimate its litigation and regulatory risks, and therefore divestment would improve risk-adjusted return. On this view, ESG investing can be a kind of profit-seeking, active investing strategy. ESG investing may also be implemented via shareholder engagement such as via proxy voting or direct contact with management.

The term “ESG investing” is thus inherently ambiguous as to motive. It can refer either to investing for collateral benefits (classic SRI) or investing to improve risk-adjusted returns (rebranded ESG), and it is widely and confusingly used in the marketplace today to encompass both. In ESG Investing by a Trustee, we clarify the umbrella term ESG investing by differentiating it into two categories. We refer to ESG investing for moral or ethical reasons or to benefit a third party, what had been called SRI, as collateral benefits ESG. We refer to ESG investing for risk and return benefits—that is, to improve risk-adjusted returns—as risk-return ESG. Differentiating between collateral benefits ESG and risk-return ESG provides taxonomic clarity by emphasizing motive—a crucial consideration under ERISA fiduciary law.

As noted above, the Supreme Court has interpreted the ERISA fiduciary duty of loyalty to require an exclusive focus on plan participants’ financial benefits. Because by definition collateral benefits ESG does not solely consider financial benefits for plan participants, it is plainly impermissible under the ERISA fiduciary duty of loyalty. As such, we generally endorse the Proposal’s proscription of use of ESG factors for other than pecuniary reasons. In the words of the Department:

The fundamental principle is that an ERISA fiduciary’s evaluation of plan investments must be focused solely on economic considerations that have a material effect on the risk and return of an investment based on appropriate investment horizons, consistent with the plan’s funding policy and investment policy objectives. The corollary principle is that ERISA fiduciaries must never sacrifice investment returns, take on additional investment risk, or pay higher fees to promote nonpecuniary benefits or goals.

Risk-return ESG, by contrast, is consistent with the ERISA fiduciary duty of loyalty, because by definition its motive is to improve risk-adjusted returns (i.e., pursuit of financial benefits for the plan participants). However, all investment strategies, whether ESG or otherwise, must also satisfy the duty of prudence. As such, we generally endorse the Proposal’s application of prudence principles to the use of risk-return ESG. In the words of the Proposal, “the Department intends, by this proposal, to reiterate and codify long-established principles of fiduciary standards for selecting and monitoring investments.”

In materials prepared in a consulting capacity for Federated Hermes, Inc., we illustrated the power of the risk-return/collateral benefits dichotomy by way of case studies of fund prospectuses thus:

  • Fund A: “Our investment objective is to seek the highest total return consistent with our prescribed environmental criteria. We seek to invest in companies that have positive environmental impacts and avoid companies with negative environmental impacts. These environmental criteria exclude securities of certain issuers for nonfinancial reasons.”
  • Fund B: “Our investment objective is to seek the highest level of current income consistent with generating environmental benefits via investment in so called ‘green bonds’ that finance projects that will have positive environmental impacts.”
  • Fund C: “Our investment objective is to seek the highest total return. We employ a responsible and sustainable investing philosophy that aligns with environmental, social, and governance values. We integrate ESG factors into our fundamental analysis to identify investment opportunities, manage risk, and pursue alpha, and we integrate ESG factors into proxy voting guidelines to minimize risk and maximize return.”
  • Fund D: “Our investment objective is to maximize total return consistent with environmental, social, and governance values. We invest across Funds A, B, and C, allocating among them in light of our analysis, which integrates ESG factors.”

Because funds A and B consider nonfinancial effects—in particular, both give consideration to environmental impacts without connection to risk and return—they employ collateral benefits ESG and therefore are impermissible under the ERISA fiduciary duty of loyalty. Fund C, by contrast, integrates ESG factors for the purpose of improving risk-adjusted returns, what in our dichotomy is risk-return ESG, hence C is permissible under the ERISA fiduciary duty of loyalty (but remains subject to the fiduciary duty of prudence). Fund D invests variously in funds A, B, and C. Because fund D includes collateral benefits ESG to some extent (via its investment in A and B), D is impermissible under the ERISA fiduciary duty of loyalty. On our reading of the Proposal, the Department would agree with our analysis of these case studies.

Risk-Return ESG is Not Inherently Suspect

As elaborated by the prudent investor rule, the ERISA fiduciary duty of prudence requires portfolio-level attention to risk and return objectives reasonably suited to the purpose of the account, diversification, cost-sensitivity, documentation, and ongoing monitoring. These principles apply neutrally to any investment decision by a trustee or other fiduciary, whether in the context of a direct investment, shareholder engagement (including proxy voting), or menu construction. Provided that the trustee or other fiduciary’s motive is pursuit of financial benefits for the plan participants, the fiduciary principles arising under the duty of prudence apply neutrally regardless of whether the trustee or other fiduciary relied on ESG factors.

Accordingly, although we generally endorse the Proposal’s application of prudence principles to use of ESG factors for pecuniary reasons (what we call risk-return ESG), we are troubled by language in the commentary and the proposed rule that could be construed as requiring application of differing or more rigorous prudence principles to ESG investing relative to other types of kinds of investment strategies.

For example, although at one point the commentary states that the “fiduciary standards” of loyalty and prudence “are the same no matter the investment vehicle or category,” at another point it states that “ESG investing raises heightened concerns under ERISA.” To be sure, we would agree that if in a given case there was evidence or specific circumstances from which to infer disloyalty, then the prohibitory rules under the duty of loyalty would apply in addition to the regulatory rules under the duty of prudence. However, we cannot agree that, as a general proposition, all investment activity broadly falling within the rubric of “ESG investing” is or should be subject to “heightened” or any other kind of different fiduciary standards. There is no basis in the statute for such a differentiation.

To the contrary, a central contribution of the prudent investor rule—both under ERISA and the Restatement and Uniform Prudent Investor Act (to which the Supreme Court has looked in interpreting ERISA)—is to eschew picking and choosing among investment vehicles or categories. The prudent investor rule prescribes neutral principles that require portfolio-level attention to risk and return objectives reasonably suited to the purpose of the account, diversification, cost-sensitivity, documentation, and ongoing monitoring.

More concerning, subsection (c)(1) of the proposed rule could be construed as imposing additional requirements for ESG investing not otherwise applicable to other types or kinds of investment strategies:

Fiduciaries considering environmental, social, corporate governance, or other similarly oriented factors as pecuniary factors are also required to examine the level of diversification, degree of liquidity, and the potential risk-return in comparison with other available alternative investments that would play a similar role in their plans’ portfolios.

These criteria ordinarily would apply to all modes of investment, whether involving ESG or otherwise, via subsection (b)(2) and background prudent investor principles. By identifying these criteria separately in subsection (c)(1) as “also” factors and tying them exclusively to “environmental, social, corporate governance, or other similarly oriented factors,” the proposed rule could be construed as applying these criteria uniquely (or at least more rigorously) to ESG and “other similarly oriented” investment strategies. In all events, we hasten to add that, owing to search costs and the infinite number of potential portfolios, the obligation to consider “other available alternatives” should be understood to require consideration of a reasonable number of alternatives. As the Seventh Circuit has noted, “nothing in ERISA requires every fiduciary to scour the market.”

We acknowledge that trust fiduciary law recognizes that there are circumstances, mainly authorized conflicts of interest, that call for enhanced scrutiny of the substance of fiduciary’s decision. But we are unaware of any authority in fiduciary investment law, ERISA or otherwise, for categorically subjecting a particular type or kind of investment strategy to different and more rigorous principles of prudence. In this respect the Proposal appears in effect to presume without foundation that, in spite of the theory and evidence that allows for the possibility of enhanced risk-adjusted returns from ESG investing, any investment involving an ESG consideration is tainted by hidden disloyal motives.

We appreciate that some may harbor doubt about the true motives of a trustee or other fiduciary. In particular, statements about risk and return, or “doing well by doing good,” could be pretextual assertions of motive or purpose via cheap talk. Concerns over hidden motives, however, are not unique to ESG investing. Fiduciary investment law addresses these concerns through the rigor of the duty of prudence, which requires that a trustee’s investment decisions to be supported by a documented reasonable analysis and subject thereafter to ongoing monitoring. If an investment strategy (whether ESG or otherwise) fails to yield its promised benefits, if other strategies present new opportunities, or if quantitative analysis of ESG factors changes, under the duty of prudence the trustee or other fiduciary will have to adapt accordingly.

A pragmatic concern also militates strongly in favor of adhering to the principle, expressed elsewhere in the commentary, that “fiduciary standards” of loyalty and prudence “are the same no matter the investment vehicle or category.” By prescribing principles applicable uniquely to ESG investing, the rule creates uncertainty and invites litigation over whether a given investment program falls within the ESG rubric—a problem that is aggravated by the fluidity and plasticity of the term “ESG investing.” As the Department recognized in the Proposal, ESG and related “terms do not have a uniform meaning and the terminology is evolving.” To take one example, virtually all mutual funds have proxy voting guidelines that consider corporate governance factors. Does this mean that those funds would fall within the “also” rules of subsection (c)(1) by virtue of their consideration of “G” factors?

All told, apart from inconsistency with the statute, we see no practical benefit to offset the uncertainty and litigation costs of creating separate categories of investment with different applicable principles. We would therefore urge revision to (c)(1) to focus on prohibiting non-pecuniary goals; to apply that rule to all investment strategies, whether ESG or otherwise; and not to state additional (“also”) principles of prudence that would apply uniquely to ESG or “similarly oriented factors.”

The foregoing analysis pertains to subsection (c)(3)(i)-(ii), which likewise could reasonably be construed as prescribing additional or different requirements for use of ESG factors in menu construction. We agree that in constructing a prudent menu for plan participants to choose from, an ERISA trustee or other fiduciary should consider “objective risk-return criteria, such as benchmarks, expense ratios, fund size, long-term investment returns, volatility measures, investment manager investment philosophy and experience, and mix of asset types” (per (c)(3)(i)) and should “document[] its selection and monitoring” processes (per (c)(3)(ii)). However, subsection (c)(3)(i)-(ii) ties those criteria specifically to funds that use “environmental, social, corporate governance, or similarly oriented assessments,” rather than unambiguously applying them neutrally to all menu construction, whether ESG or otherwise. Thus, the rule as currently drafted could be read to diminish fiduciary obligations for non-ESG investment strategies by implying that long-standing principles of prudent investing do not apply to them.

The foregoing analysis also pertains to subsection (c)(3)(iii), which excludes funds that use ESG or “similarly oriented” factors from inclusion as a Qualified Default Investment Account. In this instance, the Proposal unambiguously subjects ESG investing to a different rule than other modes of investing. Such a differentiation is not supported by the statute, is contrary to the nature of the prudent investor rule (which was meant to eschew per se categories), and invites uncertainty and litigation over whether a given investment strategy falls within the ESG investing rubric.

Suggested Clarifications

Shareholder Engagement (i.e., Active Shareholding or Stewardship). We read the Proposal, both the commentary and the proposed rule, as speaking primarily to fund or asset selection, as compared to shareholder engagement. However, as we discuss in ESG Investing by a Trustee, shareholder engagement is an increasingly common and rapidly growing area of ESG investing. Indeed, the theory and evidence in support of ESG factors in shareholder engagement is at least as strong as that in support of active investing. In our view, the same principles of prudence applicable to fund or asset selection apply to shareholder engagement, in particular cost sensitivity. We would therefore apply the rule also to shareholder engagement. At a minimum, we urge that the Department clarify its intent about the applicability of the Proposal to engagement activities generally, and the relationship of the rule to earlier sub-regulatory guidance on proxy voting specifically. But the better outcome would be to apply the rule to shareholder engagement, that is, to confirm that the same neutral principles of loyalty and prudence apply equally to all shareholder engagement, ESG or otherwise.

Active versus Passive Investing. There is language in the commentary that could be construed as expressing a preference for passive index funds relative to actively managed funds. Specifically, the commentary suggests that a shift from ESG investing may lead to more investment in “mutual funds with lower fees or passive index funds,” and in consequence, “the societal resources freed for other uses due to lessened active management … would represent benefits of the rule.” Canonical authority and case law under ERISA, however, recognizes that a trustee may employ active management strategies, such as picking and choosing among different investments. “Prudent investment principles,” in other words, “allow the use of . . . active management strategies by trustees. These efforts may involve searching for advantageous segments of a market, or for individual bargains in the form of underpriced securities.” Under the prudent investor rule, the question is whether the costs associated with a given active strategy are outweighed “by realistically evaluated return expectations.”

“Generally Accepted Investment Theories.” The Proposal references “generally accepted investment theories,” both in the commentary and in subsection (c)(1) of the proposed rule. By this term we understand the Department to be referencing the objective and relational nature of the duty of prudence, and not an intent to freeze investment practice as of the date of the rule. A key clarification, therefore, would be to explain that a soundly reasoned and supported strategy can be prudent, leaving room for innovation and improved models of asset pricing.

In all events, in accordance with our discussion above, we would revise the portion of subsection (c)(1) that references “generally accepted investment theories” to apply to all investment considerations. That is, all factors, whether ESG or otherwise, should be subject to the same requirements to qualify as a “pecuniary” factor (i.e., “only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories”).

“Economically Indistinguishable Investments.” For the reasons given in ESG Investing by a Trustee, we believe that the statute does not allow for fiduciary reliance on a nonpecuniary factor even in the case of “economically indistinguishable investments.” Setting this disagreement to the side, we believe subsection (c)(2) is a clarifying step forward from the Department’s prior sub-regulatory guidance. Crucially, by allowing a trustee or other fiduciary to rely on a non-pecuniary benefit, the rule of subsection (c)(2) involves a potential conflict of interest and so the duty of loyalty. For this reason, as noted above heightened scrutiny would be consistent with traditional principles of trust fiduciary law.

To clarify the operation of subsection (c)(2), however, we would urge further commentary and perhaps reworking of the text. We understand “economically indistinguishable investments” to mean two investments that have the same risk and return attributes. But economic equivalence requiring a tie-breaker in liquid markets is all but impossible. The risk of any two assets, even if identical on some risk metric, will nonetheless not be perfectly correlated. Thus, if there is no liquidity constraint and trading costs are low, textbook financial economics teaches that in the event of two economically equivalent investments so defined, the investor should buy both of them and achieve improved diversification. Under the portfolio-as-a-whole standard, as required by the prudent investor rule (and subsection (b)(2)(ii)(A) of the proposed rule), so-called “economically equivalent investments” do not exist in liquid financial markets.

Outside of liquid financial markets, a claim of economically indistinguishable investments must turn on a liquidity or transaction cost explanation. In other words, there must be some reason why the fiduciary cannot make both investments and thereby achieve improved diversification. In such circumstances, putting the burden on the trustee or other fiduciary to justify a finding of economic equivalence necessitating a non-pecuniary tie-breaker is an appropriate policy response.

To this we would urge an additional requirement, consistent with the policy values of the duty of loyalty, that the non-pecuniary tie-breaker be related to the interests of the plan participants, as compared to the personal views of the trustee or other fiduciary.

ESG Investing Cannot be Mandatory

Finally, anticipating that some commentators may urge the Department to mandate ESG investing, we draw the Department’s attention to the more extensive analysis of that issue in ESG Investing by a Trustee, in which we conclude that such a mandate would be contrary to law and sound policy.

In brief, with respect to law, the great innovation of the prudent investor rule was to eschew categorical rules of permissible or impermissible investments. There is no basis in the statute or background trust investment law to privilege or mandate a particular type or kind of investment strategy. As a matter of policy, there is the practical difficulty that the ESG rubric is too fluid, and the application of ESG factors too subjective, to lend itself to a mandate. Moreover, even if an investment strategy works now, there is no guarantee that it will work indefinitely. In particular, if ESG factors become increasingly reflected in market prices because of increased investor focus on them, the benefit to ESG investing will be reduced over time. Finally, even if ESG factors have relationship to firm performance, a prudent trustee could conclude that she cannot cost-effectively exploit them for profit. As recognized by the Supreme Court, an ERISA trustee could opt for a passive rather than an active investment strategy.

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