United States: Will The DOL Put The Kibosh On ESG Investing?

Last Updated: May 8 2018
Article by Cydney Posner

It would be hard to miss the increased focus of investors—especially institutional investors—on environmental, social and governance issues.  From multiple surveys showing the importance to investors of ESG factors to near-campaigns conducted by large asset managers promoting ESG as a component critical to long-term value creation, it sure seemed as if most of the private sector was getting on board. Indeed, in 2018, Laurence Fink, the Chair and CEO of asset manager BlackRock, wrote in his annual letter that, given some of the failures of governments, "society increasingly is turning to the private sector and asking that companies respond to broader societal challenges.... To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate." [Emphasis added.] But then, near the end of April, the Department of Labor issued a new Field Assistance Bulletin No. 2018-01, which provides guidance for plan fiduciaries about investments under ERISA. While Fink's letter may have seemed like an assault on Milton Friedman's theory of the primacy of maximizing shareholder value, the new DOL Bulletin has wrapped Friedman's theory in an embrace so warm it would make the presidents of the US and France blush.  (Ok, that's a big exaggeration.)

It would be hard to miss the increased focus of investors—especially institutional investors—on environmental, social and governance issues.  From multiple surveys showing the importance to investors of ESG factors to near-campaigns conducted by large asset managers promoting ESG as a component critical to long-term value creation, it sure seemed as if most of the private sector was getting on board. Indeed, in 2018, Laurence Fink, the Chair and CEO of asset manager BlackRock, wrote in his annual letter that, given some of the failures of governments, "society increasingly is turning to the private sector and asking that companies respond to broader societal challenges.... To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate." [Emphasis added.] But then, near the end of April, the Department of Labor issued a new Field Assistance Bulletin No. 2018-01, which provides guidance for plan fiduciaries about investments under ERISA. While Fink's letter may have seemed like an assault on Milton Friedman's theory of the primacy of maximizing shareholder value, the new DOL Bulletin has wrapped Friedman's theory in an embrace so warm it would make the presidents of the US and France blush.  (Ok, that's a big exaggeration.)

For many investors, ESG factors have catapulted to the top of the priorities ladder.  As reported in Compliance Week, in 2017, "more than $8 trillion under management in the United States was screened by investment firms using ESG criteria, a number that has grown by 33 percent since 2014, according to the U.S. Sustainable Investing Forum." According to the EY Center for Board Matters' survey of  investors' top priorities for companies in 2018, three of the top five investor priorities were ESG-related: board composition, with a particular focus on enhanced diversity; increased attention to climate risk and the environment; and enhanced attention to talent and human capital management.  (See this PubCo post.) As discussed in this PubCo post, a  2017 survey by EY also showed that investors were concerned about ESG issues and took information about ESG into account in making investment decisions. EY surveyed over 320 institutional investors, one-third of which had over $10 billion in assets under management, about the importance of non-financial reporting, in particular, the role ESG analysis plays in their investment decision-making. Looking at data over several years, EY found that there was a global trend toward increased interest in nonfinancial information on the part of investment professionals as well as an enhanced focus on ESG factors, albeit an informal one, in the investor decision-making process. Analyzing information over a three-year period, EY concluded that ESG factors were playing an increasingly influential role in investment decision-making. Interestingly, EY contended that ESG analysis has shifted over time from a primary focus on corporate governance issues to a now equal interest in environmental issues, particularly climate change.

EY also found that investors broadly supported the ESG themes expressed in the 2016 letter from BlackRock's Fink. That letter urged companies to increase their focus on ESG issues, such as climate change, diversity and board effectiveness, which "offer both risks and opportunities" and "have real and quantifiable financial impacts." Addressing these issues effectively can be "a signal of operational excellence," the letter contended. (See  this PubCo post.) That theme was echoed in his 2017 letter, which advocated that companies be responsible members of their communities, considering ESG factors such as "sustainability of the business model and its operations, attention to external and environmental factors that could impact the company, and recognition of the company's role as a member of the communities in which it operates. A global company needs to be local in every single one of its markets." Moreover, from a shareholder's perspective, ESG factors "can provide essential insights into management effectiveness and thus a company's long-term prospects." (See  this PubCo post.)

And, in 2018, Fink's letter emphasized that a company should consider its role in the community, its management of its environmental impact, its efforts to create a diverse workforce, its ability to adapt to technological change and take advantage of new opportunities, its retraining programs for employees in an increasingly automated world and its efforts to help prepare workers for retirement. But these goals are not just goals in and of themselves; they have a larger purpose. In the absence of "a sense of purpose," Fink contends, echoing the title of this year's letter, companies will simply "succumb to short-term pressures to distribute earnings, and, in the process, sacrifice investments in employee development, innovation, and capital expenditures that are necessary for long-term growth. It will remain exposed to activist campaigns that articulate a clearer goal, even if that goal serves only the shortest and narrowest of objectives. And ultimately, that company will provide subpar returns to the investors who depend on it to finance their retirement, home purchases, or higher education." (See this PubCo post.)

What's more, suddenly, this proxy season, environmental and social proposals were the most frequently submitted proposals, and last year, climate change proposals actually succeeded at three major companies. The proposals asked each of the companies to issue a report providing a "2 degree scenario analysis"—a term that refers to the goal of the Paris Climate Accord of limiting global temperature increases to 2 degrees Celsius (3.6 degrees Fahrenheit). The history of shareholder proposals to enhance disclosure regarding climate change has been a dismal one, but the difference last year may have been that some of the largest institutional holders—including mammoth institutional holders BlackRock and Vanguard—reportedly switched sides on some of these votes, after years of limiting their actions to just cajoling. (See this PubCo post.)

Many companies have responded to increased investor interest. According to Compliance Week, a

"recent report conducted by non-profit sustainability organization Ceres [indicates that] 43 percent of the close-to 600 companies that were analyzed proactively inform investors about their sustainability efforts. Companies' level of engagement varies by sector. Industrial companies, for example, engage investors on both sustainable business risks and opportunities. Sixteen companies in the industrial sector indicated they 'present sustainability as a business driver for product innovation, driving investment in new technologies that reduce greenhouse gas emissions and energy and water use,' the Ceres report stated. The Ceres report also found that investor activism is driving changes in the oil and gas sector. In this sector, 23 oil and gas companies disclosed sustainability information in their annual financial filings, and 52 percent informed investors about their sustainability efforts."

It is in that context that the new Administration has issued the 2018 DOL Bulletin. As explained in the Bulletin, Title I of ERISA "establishes minimum standards that govern the operation of private-sector employee benefit plans, including fiduciary responsibility rules" for plan fiduciaries making investment decisions.

With regard to the consideration of ESG factors by plan fiduciaries, the DOL's guidance has vacillated over time.  In 2008, the DOL advised, in Interpretive Bulletin 2008-01, that fiduciary consideration of collateral, non-economic factors in selecting plan investments should be rare.  Then, in 2015, the DOL issued Interpretive Bulletin 2015-01, which observed that the DOL has "consistently recognized that fiduciaries may consider such collateral goals [such as ESG factors] as tie-breakers when choosing between investment alternatives that are otherwise equal with respect to return and risk over the appropriate time horizon, " and contended that the 2008 Bulletin had "unduly discouraged fiduciaries from considering...ESG factors."  Instead, the 2015 Bulletin clarified that

"plan fiduciaries should appropriately consider factors that potentially influence risk and return. Environmental, social, and governance issues may have a direct relationship to the economic value of the plan's investment. In these instances, such issues are not merely collateral considerations or tie-breakers, but rather are proper components of the fiduciary's primary analysis of the economic merits of competing investment choices. Similarly, if a fiduciary prudently determines that an investment is appropriate based solely on economic considerations, including those that may derive from environmental, social and governance factors, the fiduciary may make the investment without regard to any collateral benefits the investment may also promote. Fiduciaries need not treat commercially reasonable investments as inherently suspect or in need of special scrutiny merely because they take into consideration environmental, social, or other such factors. When a fiduciary prudently concludes that such an investment is justified based solely on the economic merits of the investment, there is no need to evaluate collateral goals as tiebreakers. In addition, this Interpretive Bulletin also clarifies that plan fiduciaries may [make investments] based, in part, on their collateral benefits so long as the investment is economically equivalent, with respect to return and risk to beneficiaries in the appropriate time horizon, to investments without such collateral benefits."

The 2018  Bulletin puts a different twist on it, interpreting the earlier guidance as "merely recognizing 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 those cases, ESG factors may be "appropriate economic considerations."

Here, however, is the about-face: the new 2018 guidance advises that

"[f]iduciaries must not too readily treat ESG factors as economically relevant to the particular investment choices at issue when making a decision. It does not ineluctably follow from the fact that an investment promotes ESG factors, or that it arguably promotes positive general market trends or industry growth, that the investment is a prudent choice for retirement or other investors. Rather, ERISA fiduciaries must always put first the economic interests of the plan in providing retirement benefits. A fiduciary's evaluation of the economics of an investment should be focused on financial factors that have a material effect on the return and risk of an investment based on appropriate investment horizons consistent with the plan's articulated funding and investment objectives."

While, in response to participant demand, it would be acceptable to offer a "properly diversified ESG-themed investment alternative," in the case of a default investment alternative, "selecting an ESG-themed investment option for a 401(k)-type plan without regard to possibly different or competing views of plan participants and beneficiaries would raise questions about the fiduciary's compliance with ERISA's duty of loyalty." Even if investment policy statements "include policies concerning the use of ESG factors to evaluate investments, or on integrating ESG-related tools, metrics, or analyses to evaluate an investment's risk or return," the manager must disregard the policy "if it is imprudent to comply with the investment policy statement in a particular instance."

In addition, with regard to plan fiduciaries' engagement in traditional proxy voting activities, DOL guidance signals that it is not for plan fiduciaries to "routinely incur significant plan expenses to, for example, fund advocacy, press, or mailing campaigns on shareholder resolutions, call special shareholder meetings, or initiate or actively sponsor proxy fights on environmental or social issues...." Rather, more active engagement involving reasonable expenditure of plan assets may be prudent only in instances involving "important corporate governance reform issues, or other environmental or social issues that present significant operational risks and costs to business, and that are clearly connected to long-term value creation for shareholders."

Only time will tell whether the new DOL Bulletin has a significant impact on investment, voting, engagement or activism in connection with ESG issues.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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