The final DOL rules confirm that fiduciary duty includes ‘beta activism’

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November and December releases from the Department of Labor (DOL) were big wins for shareholders. Comments filed in response to the initial proposals for two rules led to favourable revisions of each rule. Those revisions make it clear that ESG considerations can enter into investment and decisions by private pension plans and that those decisions can take into account the broad economic effect of corporate behavior.

Two Proposals

In the summer of this year, the DOL (which regulates most private retirement plans in the US) proposed two rules regulating the use of ESG criteria by such plans: the first rule dealt mostly with choosing investments and the second rule addressed proxy voting.  These proposals followed years of shifting guidance under Democratic and Republican administrations, with the former largely blessing ESG questions as legitimate investment concerns and the latter putting up procedural obstacles, claiming that plans focusing on ESG were sacrificing the interests of retirees for other purposes. The 2020 proposals wfor a worldent much further than guidance under other Republican administrations, attempting to create a presumption that ESG considerations violated fiduciary duties, which would have undermined what has become standard industry practice for many investment managers and plan trustees.

Revisions Drop Anti-ESG Bias and Focus on Pecuniary Requirement

After receiving more than 15,000 responses, many of which included overwhelming evidence that ESG strategies are largely designed to increase return and/or decrease risk, the DOL reversed course and issued revised final rules (the “Investment Rule,” the “Proxy Rule,” and the “Final Rules”) that eliminated the anti-ESG presumption.  Instead, the Final Rules simply reiterate that any strategy employed by a trustee must be designed to financially benefit retirees and their beneficiaries by increasing and/or protecting the value of the assets in the plan (“pecuniary interests”). The releases accompanying the new rule (the “Investment Release,” the “Proxy Release,” and the “Releases”) emphasise that the focus had shifted from the question whether a strategy involved ESG to whether it had a pecuniary element. Thus, the Investment Release states:

Thus, the final rule removes all ESG terminology from the proposed regulatory text. The . . . regulatory requirement will be clearer and more consistent if it demands that fiduciaries focus on providing participants with the financial benefits promised under the plan and focus on whether a factor is pecuniary, rather than being required to navigate imprecise and ambiguous ESG terminology.

The Proxy Release reiterates this idea: “[T]his final rule and the financial factors rule sought to make clear that, from a fiduciary perspective, the relevant question is not whether a factor under consideration is ESG, but whether it is a pecuniary factor relevant to the exercise of a shareholder right or to an evaluation of the investment or investment course of action.”

In other words, the Final Rules clearly say that trustees can refuse to invest in companies that pollute if they believe that polluting companies ultimately make less money. But they cannot make the same decision because they want their beneficiaries to live in a cleaner world. Although some observers may hope for a world that puts the environment before profits, the Final Rules do seem to draw the line in an appropriate place, given that the job of trustees is to protect retirement income, not the planet.

Despite any disappointment that the outcome was not even more ESG favourable, the fact is that the Final Rules are a significant victory for investors with an interest in ensuring responsible conduct by portfolio companies: the proposed rules were very dangerous, because they viewed any strategy considering society or the environment as suspect, no matter how successful it might be in increasing financial returns; indeed the proposed proxy rule treated any voting at all as suspect, imposing a burden on a trustee decision to vote on any matter, although providing a safe harbour for decisions to vote as recommended by management. 

The Final Rules eliminate these presumptions. In the words of a prior Secretary of Labor describing Bush administration guidance, the initial proposals treated ESG concerns as if they “had cooties”. In contrast, the Final Rules clearly encompasses strategies of ESG integration, i.e., examining an investment through a lens that includes the effect of its social and environmental impacts on its financial returns. 

Final Rules Clear the Way for Beta Activism

In addition, Final Rules should also permit stewardship that discourages portfolio companies from engaging in behaviour that harms society and the environment, and consequently the value of shareholders’ diversified portfolios (For example, plan fiduciaries might vote to encourage all companies to lower their carbon footprint, not because it will necessarily increase return at each and every company, but because it will promote a strong economy and thus increase the return of their diversified portfolio). Such ‘beta activism’ is clearly aimed “providing participants with the financial benefits promised under the plan,” and thus “pecuniary” as the term is used in the new rule.

It is interesting to note that that both Releases carefully distinguish shareholder activism designed to improve the world in order to benefit the lives of beneficiaries from activism designed to improve the world in order to increase portfolio value. The Investment Release states:  

[T]he Department does not agree with the position that ERISA permits or requires plan fiduciaries to premise investment decisions on the idea that . . . they . . . promote a theoretical benefit to the world economy that might  redound, outside the plan, to the benefit of the participants in the plan.

The Proxy Release includes similar language: “However, vague or speculative notions that proxy voting may promote a theoretical benefit to the global economy that might redound, outside the plan, to the benefit of plan participants would not be considered an economic interest under the final rule.” This language does not preclude voting for corporate actions that could improve the economy and thus lift the market as a whole, thereby improving diversified portfolios; such activity is focused on value inside the plan, not outside it.  To the contrary, because there is a linear relationship between GDP and corporate financial returns, shareholder activism that preserves social and environmental systems critical to productivity can also protect and increase the value of assets the assets held inside a properly diversified plan.

The Role of Comments in the Discussion of Beta Activism

The Proxy Release is particularly responsive to commenters’ concerns that the initial proposed rule could be read to preclude voting directed at issues that affect portfolio values broadly, rather than only individual companies. These responsive elements of the Releases further buttress the conclusion that beta activism is permitted. For example, the Proxy Release clearly describes the concerns relating to broad portfolio issues:

• Some commenters argued that the proposal failed to recognize the potential long-term performance and economic impact of shareholder proposals on topics such as board independence and accountability—including opportunities to change a company’s board of directors, diversity, approval of auditing firms, executive compensation policies—from either an individual investment or a wider portfolio perspective.
• The final rule reflects a number of modifications made by the Department in response to the public comments. (Emphasis added.)

 The Proxy Release also specifically takes up comments around portfolio risk management:

• Commenters explained that modern portfolio theory focuses on the role that an investment plays in the context of an overall portfolio rather than on a stand-alone basis, and expressed the view that the roles that proxy voting and shareholder voices play in current portfolio risk management practices should be evaluated in the context of the long-term and portfolio-wide strategy, with consideration of the aggregate effects of shareholder votes and voices. After considering these comments, the Department has modified paragraph (e)(2)(ii)(A) and (B).
• . . .  In the Department’s view, the final rule provides sufficient flexibility for fiduciaries to consider longer-term consequences and potential economic impacts. . . . (Emphasis added.)

Finally, this question arises again in the portion of the Proxy Release that analyses the costs and benefits of the Rule, focusing on the ability of plan fiduciaries to address external costs generated by companies as a potential cost of the proxy rule.

• Several commenters noted that the analysis failed to address opportunity costs or externalities. . . . In such scenarios, voting success would not only be assessed by examining the returns to individual targeted firms’ stocks, but also by the impact on the behavior of other companies throughout their portfolios. Another commenter noted, as an example of a negative externality, a study by Arjuna Capital that emphasized the negative environmental effects of carbon emissions, which could potentially be addressed through proxy voting.
• . . . .After carefully considering such comments, the Department made several modifications to the proposed rule. The most significant adjustment from the proposal results from the Department’s agreement with the recommendation of some commenters that the final rule take a more principles-based approach to this subject matter. The Department estimates that the more principles-based approach will reduce much of the cost burden associated with the proposed rule. (Emphasis added.)

Should Beta All Fiduciaries Practice Beta Activism

In this commentary, a leading law firm cautioned pension trustees that as a result of the Final Proxy Rule, they may be required to look for ESG strategies that improve return: “Fiduciaries may want to consider whether there are new opportunities to capture improved returns or reduce risk exposures through carefully selected ESG investment approaches.” By the same token, the Final Rules and the discussion of economy-wide issues that in the Releases clarifies how beta activism – consisting of diversified owners working together to improve the return of the very market in which they are invested – is perhaps the most important responsibility a pension trustee has.

Frederick Alexander is the CEO of The Shareholder Commons, an NGO focused on moving asset owners from company-first to systems-first orientation