Legal Action Against ESG Rules and their Potential Impacts on Sustainable Investing
Socially responsible funds offered and used, per Vanguard qualified plans 2022 survey
Source: How America Saves 2022, an examination of retirement plan data from nearly 5 million defined contribution (DC) plan participants across Vanguard’s recordkeeping business.
Complaints filed against the U.S. Department of Labor 2022 ESG rule
Just four business days before they were to take effect on January 30, 2023, 25 Republican state attorney generals along with two energy companies filed a complaint in the U.S. District Court for the Northern District of Texas against the U.S. Department of Labor (DOL) seeking a preliminary injunction and permanent relief from recently adopted rules governing how retirement plan managers can consider climate change and other ESG factors. The challenge, filed on January 26, 2023, covers a “Prudence and Loyalty in Selecting Plan Investments and Shareholder Rights” 2022 rule issued by the DOL to clarify previous regulations and to remove certain barriers for plans subject to The Employee Retirement Income Security Act of 1974 (ERISA), in particular defined contribution plans such as 401(k), 403(b) and Employee Stock Ownership Plans, to select ESG investments provided that those selections are otherwise consistent with a prudent and loyal investment decision process; and also when they exercise shareholder rights, including voting on shareholder resolutions and board nominations. The rule acknowledges that ESG factors may be material to the risk-return analysis of a portfolio and that a fiduciary analysis may often require an evaluation of the economic effects of climate change and other ESG factors.
It should also be noted that in the nine days following the January 26 filing, 21 overlapping Republican state attorney generals released a letter to Institutional Shareholder Services (ISS) and Glass, Lewis & Co., two proxy voting advisory firms, in which they seek written assurances that these firms will cease from making proxy voting recommendations based on climate commitments and alignments with diversity, equity, and inclusion quotas that may be contrary to the financial interests of investment vehicles, citizens, and businesses within their states in violation of federal and state laws.
The January 26 complaint alleges that the rule conflicts with the scope of ERISA’s fiduciary duties, and is arbitrary and capricious in violation of the Administrative Procedure Act, going beyond the DOL’s authority to regulate ERISA fiduciaries to consider nonpecuniary factors in administering plan assets. Among other things, the plaintiffs contend that the rule “will not only loosen the statutory and regulatory restraints on fiduciaries to consider ESG factors, but it will also allow fiduciaries and investment managers to potentially substitute their own ESG policy preferences under the guise [of] making a risk-return determination about an investment or investment course of action.”
Legal action may check near-term decisions but not likely to affect long-term sustainable investment plans
If granted, a preliminary injunction and related legal actions will likely check any immediate actions that 401(k) plan sponsors might have taken in response to the DOL’s 2022 rule but these are not likely to affect a long-term shift to include sustainable investment options. This, even as there has only been a modest uptake to-date in sustainable investment fund options in 401(k) plans.
Socially responsible investment options continue to increase
Various surveys have found that a high percentage of defined contribution plan participants want their investments to be aligned with their values. Yet offerings are still limited, and while some research points to conflicting results, when sustainable fund options are available, the uptake is limited. Based on data derived from Vanguard’s 1,700 qualified plans and five million participants as of December 2021, offerings of socially responsible funds, limited to equity funds that take into account environmental, social, and governance factors, have been increasing at a modest pace with larger plans, or plans with over 1,000 participants, more likely to include these funds in their investment lineup than small plans. According to Vanguard’s ‘How America Saves 2022 report’, approximately 13% of plans offer socially responsible funds, up from 9% in 2017. During the same interval, the percentage of participants that use socially responsible funds increased from 3% to 6%, showing a 100% increase in total usage.
Increased adaptation coupled with additional regulatory standardization looks to bring further advancement to sustainable investing
Modest levels of participation may be due to confusion and misunderstanding regarding sustainable investing, and stepped-up employee education is needed. At the same time, the restrained uptake of investment options by defined contribution plans is likely due to the uncertainties surrounding the DOL’s fiduciary rules, but fiduciary considerations are further handicapped due to: (1) Confusion and misunderstanding that also applies to investors as well as other stakeholders regarding the various types of sustainable investing strategies that have been adopted by mutual funds and ETFs along with their financial and non-financial outcomes, if any, that have arisen due to the absence of clear definitions, lack of investment product clarity and a disclosure gap; (2) limited availability of sustainable product offerings, in terms of fundamental investment offerings and suitably long investment performance track records; (3) the challenge of offering sustainable investment options that will satisfy the sustainability preferences of a sufficiently large segment of employees. As used here, sustainable investing refers to an overarching term that encapsulates the different strategies and approaches being employed today by investment managers and is reflected in investment products such as mutual funds and ETFs. The overarching sustainable investing strategies/approaches include values-based investing, negative/exclusionary screening, impact investing, thematic investing, and ESG integration in its various forms. In addition, proxy voting and issuer engagement may be employed as an overlay by one or more of the aforementioned approaches.
Some but not all of these factors, could potentially be clarified this year when the SEC intends to finalize rules to provide additional information regarding the ESG investment practices of investment managers offering investment products. The proposed rules and form amendments seek to facilitate enhanced disclosure of ESG issues to clients and shareholders and are designed to create a consistent, comparable, and decision-useful regulatory framework for ESG advisory services and investment companies to inform and protect investors while facilitating further innovation in this evolving area of the asset management industry. In addition, the SEC is proposing to amend its fund ‘Names Rule’, and, as it relates to the application of the rule to such terms as “ESG” or “Sustainable,” the proposal would extend the ‘Names Rule’ to encompass fund strategies, including sustainable investing strategies covering 100% of portfolio assets.
Research by Sustainable Research and Analysis. Source: https://www.sustainablinvest.com