In this Ropes & Gray podcast, asset management partner Eve Ellis and ERISA & benefits partner Josh Lichtenstein discuss the recent DOL rule on ESG investing, and how managers should think about integrating these new DOL rules alongside similar but sometimes competing rules that have come out in the EU.



Josh Lichtenstein: Hello, and thank you for joining us today on this Ropes & Gray podcast. I'm Josh Lichtenstein, an ERISA partner based in our New York office. Joining me today is Eve Ellis, a partner in the asset management group based in London, who focuses on European regulatory matters for fund managers. In this podcast, we're going to be covering the recent DOL rule on ESG investing and how managers should think about integrating these new DOL rules alongside similar, but sometimes competing, rules that have come out in the EU.

So Eve, as I think about these issues, I really focus on the fact that while the DOL recently finalized its new rule on investment decisions that will require private retirement plans and asset managers to change how they approach ESG-focused investments, they also need to think about the existing framework that's of course been out there, including the EU rules. The main takeaway in my mind from the new DOL rule is that ERISA plans may still make ESG investments, but they have to focus exclusively on material pecuniary factors in making their investment selections. The term "pecuniary factors" is a new term in the lexicon in this space, and the most important thing to take away from that is that it requires that you're considering material economic factors, not just economic factors. Outside of very rare "tiebreaker" scenarios where two otherwise equivalent investments are being considered, ESG factors can really only be considered when they're financial factors, and they also must be weighted appropriately based on the expected impact of those factors on the investment being evaluated. And so as a practical matter, this means that ESG integration funds and funds which incorporate ESG as part of their return driving strategy, or as a factor to drive investment returns and diversification, will be easier for an ERISA plan to select than an impact fund or another type of fund that describes itself as being focused more on promoting social good or creating other collateral benefits in the world, in addition to driving investment returns. The new rule also prohibits using ESG funds as the default investment options for 401(k) plans in most cases, and that's significant because we know as a matter of behavioral economics, 401(k) plan participants are most likely to keep their assets invested in the default investment. Eve, what is your reaction to the DOL's new rule and its singular focus on economic factors in evaluating ESG, from the perspective of an EU regulatory lawyer thinking about how an EU fund would seek to comply with those rules?

Eve Ellis: Thanks, Josh. Taking a step back, it's worth, for those who are less familiar with the EU rule, just giving a really high-level overview of them. So there's two impending regulatory changes in relation to ESG and the EU. The first is the Sustainable Finance Disclosure Regulation (or SFDR), and the second is the Taxonomy Regulation. The SFDR probably is more pressing because that comes into force next March, and it also has broader scope. Very broadly, the SFDR will capture all managers that have a presence in the EU, but it will also capture managers that just market their products in the EU, so even if they don't have a regulated entity in the EU. They may also have an indirect impact for managers that act as sub-advisers or portfolio managers to EU-regulated entities. The other important point to bear in mind is that the SFDR impacts all products, not just those that have an ESG focus or sustainable objective. The Taxonomy Regulation, on the other hand, is only relevant if you have a fund that does have an ESG or sustainable objective. The regulations require disclosure, particularly SFDR, and the disclosures are relevant at both the manager level and the product level. Very broadly, particularly the SFDR, and I'll mention this probably more because it is more pressing and has a broader scope, require managers to have policy and procedures in place that demonstrate how they integrate sustainability risk factors into their investment decision-making process, but also in relation to other operational aspects of their business, for example, remuneration policies.

So my response and reaction to the DOL rule is that I think that there is going to be a tension there – the EU will require you to integrate sustainability risks into your investment decision-making process, and other parts of the operations. I think there is therefore a tension to the extent that those factors don't necessarily have a financial driver or financial criteria attached to them. And I think that tension is compounded for products that do have an ESG focus or sustainability objectives because for those funds, there's even more requirements in relation to disclosure that apply, and so I think that is certainly something that managers are going to have to balance in how they deal with the two slightly competing regimes.

Josh Lichtenstein: It's very interesting, Eve, because as you talk about the EU rules and about the way that they apply more broadly than just to ESG-focused funds, it's actually very similar to the DOL's rule, because the DOL's rule, in fact, doesn't even mention the words "ESG" in the final text, but similar to what you were just describing, it definitely does hit ESG funds more directly and creates more burdens.

But when I think about ESG from an ERISA perspective, the thing that I always come to is marketing materials. The new DOL rule will put a lot of pressure on asset managers to make sure that they're being reasonable and accurate in how they describe their ESG claims, and it'll be important to tell the economic story behind your ESG philosophy. This is true for any fund that may market to an ERISA plan, regardless of whether that fund is expected to hold plan assets or not, and so managers who are used to not really thinking about ERISA that much, like mutual fund managers, actually need to be prepared to make adjustments based on this rule if they want to be able to market to ERISA plans. I think that this draws on a lot of important themes in the ESG marketplace, like how you measure the economic impact of ESG factors, greenwashing and ESG integration more broadly. I can easily imagine a manager being in the room for a pitch, and that pitch, which is otherwise going well in front of an ERISA plan sponsor, becomes derailed when the presenters turn the page on their slide deck and they realize that they've included a generic slide on the ESG philosophy of the manager that includes broad philosophical claims, instead of something that's more detailed and targeted about how ESG is being incorporated for that specific fund in order to drive good returns for that fund. Do you have similar concerns about marketing materials under the EU rules?

Eve Ellis: Yes, greenwashing certainly is one of the key components – it probably is at the heart of a lot of the EU regulation, particularly the Taxonomy Regulation, and making sure a fund does what it says it's going to do and that investors are making informed decisions about what products to invest in. So trying to reduce greenwashing, really, is a key part of the regulation. Therefore, a manager can't put bold statements in its marketing materials and not be able to deliver or to explain to investors how they actually intend to meet those objectives. There's particular provisions in the SFDR, for example, that say that you're not allowed to have inconsistent marketing materials, so if you say something in your disclosure, that needs to be reflected in your marketing documentation – I think that's a really key part of the EU regime. One thing that's worth bearing in mind, particularly for ESG-focused funds, both under SFDR and under the Taxonomy Regulation, you will need to clearly disclose how you intend to meet the objective that you set out that are either part of the E, S or G or the sustainable objectives that your fund is meant to be achieving. And the Taxonomy Regulation also goes further than that, and says that you will need to disclose that you're not going to do significant harm to certain criteria that are set out in the Taxonomy Regulations. So Josh, I think that's completely right – that really is a key part of the EU regime.

Josh Lichtenstein: Interesting. You mentioned disclosure, and of course, as lawyers, we spend a lot of time thinking about and talking about disclosures and helping our clients with them. From the DOL standpoint, my main concerns about disclosure are actually pretty similar to what I was mentioning about marketing. It's important to be focused and targeted in describing how you're going to use ESG factors in your investment process, but this may be difficult when managers want to have uniform disclosure, whether it's going to appear on the website or in some sort of government-mandated or regulatory-required disclosure. I've had a lot of conversations about this with clients who are trying, understandably, to have a single global ESG policy, and then they run into issues when they need to apply that policy to funds that are being targeted towards ERISA plans. When I talk to clients about this, my advice has generally been that they really either will need to limit the way that they describe ESG in their global policies or try to change the slant or phraseology used to deemphasize the non-financial considerations, or have a separate U.S. policy or policy rider, although that isn't always ideal for global managers. Eve, I'd be curious to hear if you've had similar conversations, and how you've been thinking about these different types of challenges in advising our clients?

Eve Ellis: Yes, I definitely agree, the integration across different geographies, across different requirements and different rules is really important for people that are listening and for our clients because it's really important that as far as we can, policies are integrated, and so I think trying to look at the DOL rules, the EU rules and even investor requirements and requests is key. Thus can't be done in a vacuum – they really do need to be looked at across the different rules because ESG just permeates so much of the business. So I think one of the things that we're saying to clients when it comes to the EU piece is, we need to look at the EU piece, we need to do a clear scoping exercise and gap analysis, look at the requirements, but a really important aspect of your SFDR road map is working out how it integrates across the different requirements, so that if you have ERISA investors are part of your investor base, we do try and address as far as we can the DOL requirements. As many investors have been driving for many years, even before the regulatory change, ESG is a clear focus for most, and so making sure that both requirements are built into any policy that is put in place to deal with SFDR – and as I say, not looking at it in a vacuum, I think, is so important. The other thing that I would say is that SFDR has "disclosure" in the name, and disclosure is key, but a lot of the disclosures relate to underlying policies and procedures. So it's not going to be sufficient from an EU perspective to put the disclosure on the website, necessarily. There will need to be policies and procedures that back up those disclosures, and I think that's probably the key part of the implementation process. So for those managers that are listening that have got more complex global structures with different regulated managers and with different types of products, that scoping exercise, and then looking at how it integrates across the business as a whole, I think is really important.

Josh Lichtenstein: Yes, that's such an interesting aspect of all of this. There are these conversations that we would have historically thought of as being isolated to just one geography or one segment of the market, and now we're thinking of them on more of a global basis. I think that a trend that's going to endure and be accelerated by all these types of rules is that more and more of what we do is becoming global. But another place where I think that it's interesting to think about is differentiation among different types of targeted investors, and as I mentioned before, different types of plans in the U.S. will actually react to the DOL's rule in different ways. For a traditional defined benefit pension plan, the rule will mostly influence what their investment diligence process looks like and how they document the process. So if you're trying to sell a product to one of these investors, it's very important to focus on what you're presenting to the committee, to the fiduciary, to make sure that the fiduciary is able to easily document how they went through the appropriate process under these rules and weren't unduly influenced by non-financial ESG aspects of the investment or other non-financial aspects. But for a participant-directed contributory plan, like a 401(k) plan, the rule will actually be fairly different because it will likely result in ESG options having to be selected to be alternatives to other similar funds on an investment lineup, but very few ESG funds being incorporated in any way into the default investment. As I said before, that has direct ramifications for the amount of dollars that you can expect plan participants to allocate to these products. For the state-sponsored plans, which are obviously very large investors in private funds, the impact is less direct because the rule doesn't actually apply to them. But the rule does influence how ERISA fiduciaries act, and it's very common for these state plans to ask an asset manager to agree by contract to act like it's an ERISA fiduciary when managing assets on the state plan. If that's the case, then the rule likely would influence the investment process, unless there's an explicit contractual carve-out saying that a manager agrees to act as if it's an ERISA fiduciary, but the avoidance of doubt will not be required to comply with the new ESG rules. Eve, do you think the different classes of investors will need to be treated differently under the EU regime?

Eve Ellis: The EU rules don't distinguish between investors, Josh, so there's no specific requirement that you'll need to treat different investors in different ways. The one point I would make, though, is that some investors have their own requirements, there are some additional rules that will impact listed institutional investors, for example. So they will need to be able to comply with their own regulatory obligations when it comes to ESG. Also, there may well be some institutional investors that themselves are regulated, and therefore subject to the SFDR and Taxonomy Regulation. So that may have an impact on how they interact with the managers, but the rules themselves, the SFDR and Taxonomy Regulation, don't distinguish between investors in the same way as I think you described.

Josh Lichtenstein: Interesting. So far we've been talking, and there's been, I think, a lot of confluence in framework, although a lot of the substance is different. This is a place where the framework is also fairly different. Turning to a slightly different topic, I know I've had some difficult conversations with clients about some hard choices that they're evaluating based on all of these new rules that are coming out. I've seen clients that were planning on offering some ESG-focused funds that would be targeted at ERISA plans, and I have seen them abandon those. I've also seen clients consider starting separate funds just for their ERISA investors so that they could have very clear separations in the way that the marketing gets handled and the way the investment process weights ESG factors for the different products. I've seen clients consider how they could change the descriptions of their ESG diligence process or ESG philosophy based on the DOL rule, even though that doesn't necessarily align with what they'd like to do from a business standpoint. Eve, have you had similar hard conversations with clients, seeing them take steps to comply with rules, which may not really align with their business goals?

Eve Ellis: Not yet. I think with the EU rules, particularly the SFDR, they're still evolving and we're still waiting for guidance, and there are certain standards that have been postponed that I think will see where they settle in terms of how prescriptive and burdensome some of the rules are to comply with. So I haven't seen managers have to make those hard decisions as to whether they want to deemphasize ESG factors, even if they don't want to from a business perspective, but I do worry that that could happen, which clearly is not what the policymakers intended. But to the extent that these rules become so prescriptive and become difficult to comply with and go beyond what the manager is choosing to do, given its investment objectives, strategy, and given its investors, I worry that there could be a shift – and I'll just say, that that's clearly not what was envisaged.

Josh Lichtenstein: It's interesting to hear, Eve, that there's been, even though the EU rules may be actually more fleshed out in some ways than DOL's rule is and maybe broader in scope, it seems like there's already been some more concrete, hard decisions that have had to be made by some of our U.S. managers or our global managers, thinking about marketing to ERISA plans under the DOL rule. So as our global asset manager clients and our EU-focused asset manager clients are thinking about all these different issues, if there was just one takeaway that you would leave them with. what would it be?

Eve Ellis: Thanks, Josh. If I can be cheeky and take two takeaways. I think the first takeaway is, from an EU perspective, now is the time to take action in terms of considering how the EU rules are going to impact your business and your products. The rules come into force on the tenth of March next year, as I've mentioned, and I think particularly for people that are listening that have got more complex, global structures, it's really important that you start thinking about the EU rules and how they interact across your business, and other rules. I think the other takeaway is how managers integrate the DOL rule and the EU rule is really important. And I think one of the takeaways is that if this is carefully considered, it can be achieved. While the DOL rule is looking at ensuring that you put weight on financial criteria and financial factors, and the EU rule is saying that you need to integrate sustainability risk into your investment decision-making process, it doesn't say that you can't put weight to financial criteria. I think there are ways that the two can be considered, but I think it does need careful consideration and it needs to be balanced against the DOL requirement that these factors carry financial or economic weight as well as ESG consideration.

Josh Lichtenstein: Those are both really, really great points, and I agree completely. I think that there's somewhat of a tightrope, but that doesn't mean that it can't be walked – just have to be very, very careful in making sure that you're meeting your obligations under the EU rules without running afoul of prohibitions under the DOL rule. Thank you, Eve, for joining me for this really interesting discussion. And thank you to our listeners. For more information on the topics that we discussed today, or any other topics of interest to the global asset management community, please visit our website at Of course, we'd be happy to navigate any of the topics we've discussed, so please don't hesitate to get in touch. You can also subscribe or listen to this series wherever you regularly listen to podcasts, including on AppleGoogle and Spotify. Thank you again for listening.


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.