On September 21, 2023, the United States District Court for the Northern District of Texas, in Utah v. Walsh, upheld DOL’s 2022 amendment (the 2022 Rule) of its 2020 Environmental, Social, and Governance (ESG) investing and proxy voting rules (the 2020 Rule), rejecting claims by 26 states and other interested parties that the rule violated ERISA and the Administrative Procedure Act (APA). The court found that “[t]he 2022 Rule changes little in substance from the 2020 Rule and other rulemakings”, and that the process by which DOL (in 2022) amended the 2020 Rule adequately addressed issues raised by plaintiffs and was therefore not “arbitrary and capricious.”
The 2022 Rule was understood to significantly relax restrictions on ESG investing, eliminating special restrictions on ESG investments in defined contribution default investments (such as 401(k) plan target date funds), making the “tiebreaker” rule, which allows consideration of non-financial issues in certain circumstances, more flexible, and eliminating recordkeeping and disclosure requirements with respect to the tiebreaker rule. The court’s decision in effect (and for the moment at least) puts a judicial stamp of approval on the 2022 Rule, removing whatever doubt there may have been about its legal viability.
In this article we review the court’s decision.
There has been, since the 1990s, a tug of war between administrations over the content of DOL guidance with respect to ESG investing and plan fiduciaries’ obligations with respect to the exercise of shareholder rights (e.g., proxy voting) for plan-held securities. At the end of the Trump Administration (in 2020), DOL finalized amendments (the 2020 Rule) to its ERISA investment duties and proxy voting rules, tightening in some respects the rules with respect to ESG investing and to some extent “downplaying” fiduciaries’ obligations to exercise shareholder rights.
On taking office, President Biden issued an Executive Order instructing DOL to review the 2020 Rule. In October 2021, DOL proposed amendments to the 2020 Rule, in effect backpedaling on a number of its features, and then published final amendments to the 2020 Rule on December 1, 2022, (the 2022 Rule).
Plaintiffs make two broad claims:
The 2022 Rule conflicts with ERISA – plaintiffs identified the 2022 Rule’s treatment of tiebreakers and its “implicit authorization [of fiduciaries] to consider nonpecuniary factors in proxy voting” as the 2022 Rule’s “most apparent” “deviation” from the intent of ERISA’s exclusive purpose/fiduciary duty of loyalty rule.
The rule violates the APA’s arbitrary and capricious standard – plaintiffs argued that DOL’s 2022 rulemaking process violated the APA standard in several respects, including that it had: (1) ignored relevant considerations, critically the possible harm to participants the rule might cause; (2) made unjustified changes to the 2020 Rule, e.g., while DOL justified its 2022 rulemaking because of the “chill” and “confusion” caused by the 2020 Rule, it “never identified who was confused, what the source of confusion was, or whether the alleged confusion caused a reduction in the financial returns for plan participants;” (3) inadequately explained other changes, e.g., the elimination of proposed disclosure of non-financial “collateral factors” considered in selecting an investment for a defined contribution plan fund menu; (4) did not consider alternatives, e.g., sub-regulatory guidance; (5) made “unreasoned changes” (see our discussion below with respect to tiebreaker documentation); and (6) had “prejudged” the issues, that is, before proposing the rule and soliciting comments DOL had already determined its main principles.
The 2022 Rule does not violate ERISA
In analyzing whether the 2022 Rule violated ERISA, the court applied the “Chevron” doctrine, under which, where Congress has not “directly spoken to the precise question at issue,” courts are to defer to the agency decision where it is not “arbitrary or capricious in substance, or manifestly contrary to the statute.”
The court found that, with respect to the 2022 Rule’s treatment of tiebreakers, “[b]ecause ERISA does not contemplate the possibility of a ‘tie’ between two financially equivalent investment options, Congress has not ‘directly spoken to the precise question at issue.’” And that “the reasonableness of DOL’s interpretation is supported by its prior rulemakings – including the 2020 Rule [which also allowed consideration of collateral factors in the case of tiebreakers, albeit under tighter/stricter terms].”
More broadly, the court found that:
[A]n ESG factor could be worth consideration even under prior rules if it “is expected to have a material effect on the risk and/or return of an investment.” … Similarly, the 2022 Rule states that risk and return factors may include ESG factors under some circumstances, but those factors must still reflect “a reasonable assessment of its impact on risk-return.” … In other words, the 2022 Rule “provides that where a fiduciary reasonably determines that an investment strategy will maximize risk-adjusted returns, a fiduciary may pursue the strategy, whether pro-ESG, anti-ESG, or entirely unrelated to ESG.” … And like prior rules, the 2022 Rule allows consideration of collateral factors to break a tie. Thus, after affording DOL the deference it is presently due under Chevron, the Court cannot conclude that the Rule is “manifestly contrary to the statute.”
The 2022 Rule is not arbitrary and capricious under the APA
The court found, generally, that the DOL’s process was adequate under the APA. In that regard, it found that:
DOL had, citing findings in the preamble to the 2022 Rule, adequately explained “its position that the 2020 Rule had a chilling effect on fiduciaries’ consideration of pertinent information when making investment decisions.”
DOL had adequately justified its decision to delete “the proposed rule’s prohibition on exercising proxy rights to ‘promote non-pecuniary benefits or goals unrelated to those financial interests of the plan participants and beneficiaries’” on the basis that concerns about this language (e.g., that it might be “easily misconstrued”) were justified and the principle at issue was addressed adequately by the rule’s requirement that fiduciaries to act “solely in accordance with the economic interests of the plan.”
The decisions to eliminate the prohibition of ESG funds in qualified default investment alternatives (QDIAs – e.g., a target date fund) and the additional disclosure requirements for ESG funds in participant directed DC plans were justified based on comments DOL had received.
There is always the possibility that the court’s decision may be reversed on appeal. But for the moment this decision puts to rest the court challenge to DOL’s 2022 Rule. For sponsors considering ESG investments, that is good news.
We note that there is ongoing litigation (also in the Northern District of Texas) over the application of DOL’s Rule (and ERISA generally) to alleged fiduciary decisions to include ESG investments in a participant-directed DC plan’s fund menu. In that regard, we recently published an article on ESG investing – sponsor fiduciary risk.
Finally, we note that, given the back and forth between Democratic and Republican administrations on this issue, if a Republican wins the presidency in 2024, we could see yet another amendment to these rules. (In this regard, see, e.g., our article Criticism of current proxy voting policy – the Republican House Financial Services Committee Working Group.)
We will continue to follow this issue.