Building on a trend in the United States in favor of “socially responsible investing,” some investors appear to be increasing their investments in mutual funds and
What is “ESG”?
ESG factors refer to non-financial information related to corporate behaviors, policies, and operations such as (1) environmental compliance, including greenhouse gas emissions, climate change risks, water usage and supply, energy usage, waste materials, land use, and impact on natural resources; (2) social performance, including human rights, employee safety and welfare, community involvement, and local economic development; and (3) governance, including shareholder relations, ethics policies, board-level responsibilities, and dedication of board resources to ESG matters.
While many investors dismissed non-financial data years ago as irrelevant to investment decisions because it did not speak directly to the bottom line, some investors now regard reported ESG performance as relevant to the company’s future financial performance. These investors consider ESG factors to be material in some contexts and incorporate those factors into investment decisions.
ERISA Fiduciary Duties
U.S. private sector retirement plans are governed by ERISA. ERISA plan fiduciaries have several statutory duties that are the highest duties known to law. Those duties include: (i) the duty to act loyally to plan participants and beneficiaries, i.e., in their exclusive interests; (ii) the duty to act prudently, i.e., with the care, skill, prudence, and diligence under the circumstances then prevailing; (iii) the duty to diversify, i.e., diversify plan investments to minimize the risk of large losses; and (iv) the duty to act in accordance with the plan documents to the extent consistent with ERISA.
DOL Guidance on ESG Investing
The DOL regulates employee benefit plans and the management of those plans by fiduciaries. Since 1994, the DOL has issued a handful of guidance documents (changing with each administration) addressing the extent to which plan fiduciaries may consider ESG concerns as part of their investment strategies. The DOL’s most recent guidance, Field Assistance Bulletin No. 2018-01 (FAB 2018-01 or Guidance) (Apr. 23, 2018),3 makes clear that plan fiduciaries “must not too readily treat ESG factors as economically relevant” and advises that “[i]t does not ineluctably follow from the fact that an investment promotes ESG factors . . . that the investment is a prudent choice for retirement or other investors.” Stated another way, “ERISA fiduciaries may not sacrifice investment returns or assume greater investment risks as a means of promoting collateral social policy goals.”4
With that said, the Guidance also observes that the DOL has recognized limited circumstances in which such collateral considerations can serve as “tie-breakers” provided that two potential investments otherwise serve a plan’s economic interests equally well. The current Guidance refines this point, stating that:
there could be instances when otherwise collateral ESG issues present material business risk or opportunities to companies that company officers and directors need to manage as part of the company’s business plan and that qualified investment professionals would treat as economic considerations under generally accepted investment theories. In such situations, these ordinarily collateral issues are themselves appropriate economic considerations, and thus should be considered by a prudent fiduciary along with other relevant economic factors to evaluate the risk and return profiles of alternative investments. In other words, in these instances, the factors are more than mere tie-breakers.
The Guidance also reiterates that a plan fiduciary may add ESG-themed investment alternatives to a 401(k) plan’s investment lineup, provided that such an addition does not cause other
Lack of Uniform ESG Data and Reporting Discourages ESG Plan Investment Options
One reason plan fiduciaries may be unwilling to take the leap into ESG-themed investments may be the absence of standardized reporting of ESG criteria, which inhibits the ability to incorporate ESG-themed investments in a prudent selection process. While ESG information has sometimes been used to benchmark companies by industry sector based on the number of ESG disclosures made by a company compared to a peer company, the investment community appears to have difficulty in comparing the substance of companies’ ESG disclosures. This may be due, in part, to the numerous voluntary ESG-reporting frameworks and the extent to which a given framework is applied.6 In the absence of standardized reporting, plan fiduciaries may have difficulty quantifying when or how much the ESG criterion will affect the bottom line.7
There are some efforts underway to standardize the reporting of ESG factors. There is no concrete evidence, however, that any of these efforts will bear fruit in the near future. This may be due in part to the fact that the standard-setting organizations involved, and the reporting products offered, vary with respect to risk factors considered. A non-exhaustive list of standard-setting organizations includes the Sustainability Accounting Standards Board (SASB), which focuses on public companies identifying and reporting material, industry-specific ESG issues of importance to investors; the Global Reporting Initiative (GRI), which is often used in sustainability reporting by corporations and other entities and serves a broader range of stakeholders; and the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD), which promotes using scenario analysis to assess and disclose climate change-related risks of interest to investors, lenders, insurers, and other stakeholders.
It does not appear that FAB 2018-01 will cause many ERISA plan fiduciaries to alter their thinking when it comes time to evaluating and selecting investment options for private sector employee benefit plans. While the Guidance provides some additional clarity surrounding the DOL’s position on ESG-themed investments, the bottom line is that plan fiduciaries must always act in accordance with their fiduciary duties in selecting investment options and consider all the appropriate facts and circumstances. In some cases, as the DOL noted, that may include ESG issues, but only if relevant ESG factors are material in nature. It remains the case that ESG issues do not in and of themselves make an employee benefit plan investment option prudent. Unless and until there are more precise and reliable means to measure ESG factors and to weigh them together with the other factors relevant to a prudent investment decision-making process, it seems unlikely that there will be
Russell L. Hirschhorn, Proskauer Rose LLP
Thomas A. Utzinger, Washington, DC
* Russell L. Hirschhorn, Partner, Proskauer Rose LLP (Management Co-Chair, ABA Labor & Employment Section, Employee Benefits Committee) and Thomas A. Utzinger (Newsletter Vice Chair, ABA Section of Environment, Energy, and Resources Environmental Disclosure Committee).
1 Jon Hale, What are Sustainable Funds and How Have They Performed?, Morningstar (Jan. 31, 2018), https://www.morningstar.com/blog/2018/01/31/sustainable-funds.html (observing that in 2017 there was $95 billion invested in ESG funds, and by the end of that year there were 235 ESG funds in 56 Morningstar categories available to U.S. fund investors); Georg Kell, The Remarkable Rise of ESG, Forbes (July 11, 2018), https://www.forbes.com/sites/georgkell/2018/07/11/the-remarkable-rise-of-esg/#19a947481695 (tracing the rise of ESG investing and its acceptance by the mainstream investing community).
2 It has been reported that only 2.4% of 401(k) plans currently offer ESG funds. See Sarah Krouse, Don’t Choose Ethics over Profits in Your 401(k), Government Warns, Wall Street J. (Apr. 27, 2018), https://www.wsj.com/articles/dont-choose-ethics-over-profits-in-your-401-k-government-warns-1524835810; Amy Whyte, For all the Hype, Almost No U.S. Plans Factor in ESG, Institutional Investor (July 23, 2018), https://www.institutionalinvestor.com/article/b194wq9pq8qcnb/For-allthe-Hype-Almost-No-U-S-Plans-Factor-in-ESG (12% of U.S. corporate and
3 U.S. Department of Labor, Field Assistance Bulletin No. 2018-01 (Apr. 23, 2018), https://www.dol.gov/agencies/ebsa/employers-and-advisers/guidance/field-assistance-bulletins/2018-01.
4 FAB 2018-01 builds on two Obama-era Interpretive Bulletins from 2015 and 2016. The first bulletin, IB 2015-01, relates to
5 In the event plan participants do not make investment elections upon enrollment, investments will be allocated to the plan’s QDIA. QDIAs are generally diversified investments with appropriate time horizons.
6 A recent U.S. Government Accountability Office (GAO) Report notes that “the quality of data available on ESG factors” is a concern to employee benefit plan managers, and that “in the absence of specific reporting requirements, company disclosures on ESG factors may be incomplete or inaccurate because companies have the discretion to determine what information they provide.” GAO, Retirement Plan Investing: Clearer Information on Consideration of Environmental, Social, and Governance Factors Would be Helpful, GAO-18-398 (May 22, 2018), https://www.gao.gov/products/GAO-18-398.
7 For instance, there is no overarching Securities and Exchange Commission (SEC) rule mandating ESG disclosures in public filings. The SEC published an interpretive release in 2010 addressing how SEC disclosure requirements apply to climate change risks such as climate-related legislation and regulation, international accords, indirect consequences of regulations or business trends, and physical impacts. SEC, Commission Guidance Regarding Disclosure Related to Climate Change, 75 Fed. Reg. 6,290 (2010), https://www.gpo.gov/fdsys/pkg/FR-2010-02-08/pdf/2010-2602.pdf. Implementation of this SEC guidance has varied widely. By contrast, the 2014/95/EU and 2016/2341/EU directives establish certain requirements for the disclosure of ESG factors.