By: Keith L. Johnson, Heads of Institutional Investor Legal Services, Reinhart Boerner Van Deuren s.c., Member of the IEN Executive Committee, and Chair of the IEN Fiduciary Duty & Policy Working Group
April 27, 2018
Investor fiduciaries should be careful not to overreact to Employee Retirement Income Security Act (ERISA) Field Assistance Bulletin 2018-01 on the exercise of shareholder rights and consideration of Environmental, Social and Governance (ESG) factors, which was issued by the Department of Labor (DOL) on April 23, 2018.[1] Some are reading it as backtracking on assurance about consideration of material ESG factors and related company engagement practices contained in interpretive bulletins that were issued in 2015 and 2016.
Tone of the Bulletin is definitely harsher. However, a close reading shows it still confirms that ESG factors can present material investment considerations which fall within an investor fiduciaries' primary risk/return analysis and do not constitute collateral social policy goals. The Field Assistance Bulletin restates DOL's prior 2015 and 2016 guidance that integration of material ESG factors into investment and proxy voting policies and decisions is consistent with fiduciary duty. For example, it recognizes:
"The preamble of IB 2015-01 added: '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 [(ESG)] factors, the fiduciary may make the investment without regard to any collateral benefits the investment may also promote.'”
"In making that observation, the Department merely recognized 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 such situations, these ordinarily collateral issues are themselves appropriate economic considerations, and thus should be considered by a prudent fiduciary along with other relevant economic factors to evaluate the risk and return profiles of alternative investments. In other words, in these instances, the factors are more than mere tie-breakers."
However, the Field Assistance Bulletin also recognizes that there are fiduciary duty guardrails which preclude using ERISA funds to give up return or take on added risk in pursuit of collateral social policy goals.
The DOL cautions that investment analyses must start from an evaluation of financial factors that have a material effect on return and risk over appropriate time horizons (i.e., usually including over the long term). A prudent approach should not favor a particular belief or policy without determining its financial materiality over those time horizons. (Although the Bulletin does not explicitly address it, this should apply equally to conservative and liberal beliefs.) The 2015 and 2016 Bulletins did nothing to repeal this standard fiduciary obligation. The Field Assistance Bulletin puts it this way:
"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."
The Field Assistance Bulletin also confirms that "investment policy statements are permitted to 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." (Emphasis added.) However, it notes this does not mean that investment policy statements must include ESG guidelines.
In addition, the Field Assistance Bulletin quotes Interpretive Bulletin 2016-01 in confirming that that corporate engagement practices can be prudent:
"[There] may be circumstances, for example involving significantly indexed portfolios and 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 with respect to which reasonable expenditure of plan assets to more actively engage with company management may be a prudent approach to protecting the value of a plan's investment."
However, the DOL observes again that there are fiduciary duty guardrails to keep fiduciaries focused on determining the net economic benefit of routine or substantial expenditures for corporate engagement, supposedly with attention to benefits over the appropriate time horizons. While this could discourage engagement practices, it seems to merely reinforce the existing principle that investor fiduciaries should always undertake a fact-based and deliberative process that is informed by qualified expert advice when executing investment management responsibilities.
Fiduciaries are well advised to document their approach to development of ESG policies or practices. Over the past few years, there has been a growing amount of new research on ESG materiality which should be referenced. This is an area that is undergoing rapid change. ESG doubters and believers alike should check current facts and undertake a reasoned analysis when developing proxy voting and engagement practices.
Company ESG engagement practices have always merited the same level of analysis as used in establishing investment strategy or making security buy and sell decisions. Furthermore, the Field Assistance Bulletin avoids a negative mandate by using the phrase “may well” (rather than must) when it says:
"If a plan fiduciary is considering a routine or substantial expenditure of plan assets to actively engage with management on environmental or social factors, either directly or through the plan’s investment manager, that may well constitute the type of “special circumstances” that the IB 2016-01 preamble described as warranting a documented analysis of the cost of the shareholder activity compared to the expected economic benefit (gain) over an appropriate investment horizon."
Finally, the Field Assistance Bulletin does not repeal the 2015 and 2016 Interpretive Bulletins that have given comfort to fiduciaries in acting on current research about the risk and return implications of material ESG factors. Those Interpretive Bulletins are still in effect. The Field Assistance Bulletin can be read as simply observing that fiduciary duty guardrails exist to ensure that ERISA fiduciaries and their service providers do not take shortcuts. Perhaps concerned investors just need to up their game, establish higher expectations for their service providers and document the related analytical processes.