On Oct. 16, 2008, the U.S. Department of Labor (“DOL”) announced that it was issuing new guidance clarifying the obligations of ERISA plan fiduciaries when considering shareholder rights and investments in economically targeted investments (“ETIs”). The guidance took the form of updates to prior interpretive bulletins on ETIs and proxy voting that were issued in 1994, reflecting subsequent guidance and, in the case of ETIs, incorporating a series of examples.

While DOL expressed strong concerns about ETIs and other types of social investment activities, and the risk to fiduciaries of not making investment decisions based on what is in the interest of plan participants, the interpretive bulletins do not reflect a substantive change in the law on this issue. DOL did modify its prior position on proxy voting to indicate that a fiduciary can take costs into account in deciding whether to vote proxies, a view that it previously limited to proxies on foreign investments.

Economically Targeted Investments

The original guidance on ETIs (defined as investments selected for the economic benefits they create apart from their investment return to the plan—also referred to as “social” investing) was Interpretive Bulletin 94-1. It indicated that while DOL had construed the ERISA fiduciary provisions as prohibiting a fiduciary from subordinating the interests of participants and beneficiaries in their retirement income to unrelated objectives, the selection of an ETI, or engaging in an investment course of action intended to result in the selection of ETIs, would not violate ERISA so long as the following requirements were met: that the investment not be expected to provide the plan with a lower rate of return than available alternative investments with commensurate degrees of risk, or be riskier than alternative available investments with commensurate rates of return.

The updated guidance, Interpretive Bulletin 08-1, retains that general rule. However, it adds a discussion emphasizing that fiduciaries must, in making investment decisions, focus on the economic interests of the plan. It says that given the significance of ERISA fiduciary requirements, a fiduciary must, before selecting an ETI, “have first concluded that the alternative investment options”—those that would fill a similar role in the plan’s investment portfolio with regard to risk, return, diversification and liquidity—“are truly equal, taking into account a quantitative and qualitative analysis of the economic impact on the plan.” A less rigid rule, said DOL, “would allow fiduciaries to act on the basis of factors outside the economic interest of the plan in situations where reliance on those factors might compromise or subordinate the interests of plan participants and beneficiaries.” DOL further noted that in light of ERISA’s rigorous requirements, “fiduciaries who rely on factors outside the economic interests of the plan in making investment choices and subsequently find their decision challenged will rarely be able to demonstrate compliance with ERISA absent a written record demonstrating that a contemporaneous economic analysis showed that the investment alternatives were of equal value.”

This statement of DOL’s position—which was based in part on recent advisory opinions DOL issued to the U.S. Chamber of Commerce—was supplemented by five examples, all situations that DOL believed to potentially contravene the basic rule that a plan fiduciary focus on the economic interests of the plan in making investment decisions. The five examples are:

  1. A plan owns an interest in a limited partnership that is considering an investment in a company 1. that competes with the plan sponsor. According to DOL, the plan fiduciaries may not replace the limited partnership investment to avoid investing in a competing company unless they can prudently determine that a replacement investment is economically equal or superior to the limited partnership investment.
  2. A construction industry multiemployer plan wants to invest in a large loan for a construction 2. project located in the same area as its plan participants, to create local jobs. However, the plan has already made several other construction loans in the same metropolitan area. According to DOL, the fiduciaries may not choose this investment on the basis of local job creation where, because of diversification issues, the investment would not be of equal economic value to the plan as construction loans outside its local area.
  3. A plan is considering investing in a bond that would finance local affordable housing. The bond, 3. while providing a favorable investment return for its level of risk, is of such size and duration as to raise liquidity issues, while other available bond investments do not pose the same issues. Therefore, DOL concluded, the fiduciaries may not make this investment, because it is not of equal or greater economic value than other available investments.
  4. A plan sponsor adopts an investment policy that favors investments in companies meeting certain 4. “green” environmental criteria. In carrying out this policy, said DOL, the plan fiduciaries may not limit their consideration to “green” companies, but must consider all investments that meet the plan’s prudent financial criteria, and may eliminate non-green companies from consideration “only if they appropriately determine that other available investments provide equal or better returns at the same or lower risks, and would play the same role in the plan’s portfolio.”
  5. A collective fund is designed to invest in commercial real estate constructed or renovated with 5. union labor. DOL said that fiduciaries of plans that invest in the fund “must determine that the fund’s overall risk and return characteristics are as favorable, or more favorable, to the plans as other available investment alternatives that would play a similar role in their plans’ portfolios.” The fund’s managers, as managers of plan assets governed by ERISA, would also be subject to these rules, and may select union labor investments if their economic analysis indicates that these investments are equal or superior to their alternatives, a justification that DOL said should be recorded in writing. However, if economically equal or superior union labor investments are unavailable, DOL said that the fund managers may have to select investments without regard to the union labor criteria.

Proxy Voting

The original proxy voting guidance was Interpretive Bulletin 94-2. Drawing on several DOL advisory opinions and information letters, it emphasized the importance for plan fiduciaries of maintaining statements of investment policy and of exercising a plan’s proxy voting rights.

The part of the bulletin on investment policies declared that a statement of proxy voting policy would be an important part of any comprehensive statement of investment policy, and it described the importance of complying with such a policy unless it would be imprudent or contrary to the economic interest of plan participants to do so. The proxy voting portion of the bulletin described the fiduciary obligation to vote proxies based solely on those factors that may affect the value of the plan’s investment, and to monitor managers’ proxy voting activities. It acknowledged that there may be costs in voting proxies of foreign corporations, permitting the fiduciary to weigh those additional costs versus the expected effect on the value of the plan’s investment in determining whether to vote those shares, but did not indicate that any cost-benefit analysis would be permitted in determining whether to vote proxies for domestic investments. The 1994 bulletin also discussed shareholder activism, and indicated that this would be permitted where there is a reasonable expectation that such activities would be likely to enhance the value of the plan’s investment after taking any related costs into account.

Interpretive Bulletin 08-2 updates Interpretive Bulletin 94-2. The portion of the bulletin on statements of investment policy is virtually unchanged, but the other parts of the bulletin have been substantially revised.

The proxy voting portion has been modified to include a discussion of weighing the cost of voting versus the benefits, even for domestic investments. If the responsible fiduciary “reasonably determines that the cost of voting (including the cost of research, if necessary, to determine how to vote) is likely to exceed the expected economic benefits of voting, or if the exercise of voting results in the imposition of unwarranted trading or other restrictions, the fiduciary has an obligation to refrain from voting.” The bulletin further emphasizes this point by stating that fiduciaries, in voting proxies, must consider not only how the vote may affect the economic value of the plan’s investment, but they “also need to take into account costs when deciding whether and how to exercise their shareholder rights,” including such costs as “expenditures related to developing proxy resolutions, proxy voting services and the analysis of the likely net effect of a particular issue on the economic value of the plan’s investment.”

The discussion of shareholder activism has been revised to place more emphasis on the need to consider whether the activities would be reasonably likely to affect the economic value of the plan’s investment, and to point out that a fiduciary may not use plan investments to promote public policy preferences (an issue raised in the recent advisory opinions to the U.S. Chamber of Commerce referred to above). There is an added discussion of “socially-directed proxy voting, investment policies and shareholder activism,” which makes the same basic point – that if fiduciaries engage in proxy activities aimed at furthering legislative, regulatory or public policy issues, they must be “prepared to articulate a clear basis for concluding” that those activities are “more likely than not to enhance the economic value of the plan’s investment.”

Observations

The 1994 interpretive bulletins were issued at a time when the governing Administration favored socially oriented investment activities. The guidance was intended to describe the circumstances in which plan fiduciaries could make ETI investments without contravening their fiduciary responsibilities under ERISA, and also to indicate under what conditions plan fiduciaries could permissibly engage in shareholder activism. The proxy voting guidance was intended to emphasize the responsibility of fiduciaries to vote proxies on plan investments, an outgrowth of then-recent DOL guidance and a proxy voting survey that was grounded in a belief that proxies are a plan asset that should be utilized to enhance the value of plan investments.

The 2008 interpretive bulletins represent a different perspective. Instead of being designed to encourage ETI investments and shareholder activism by hesitant fiduciaries, they appear intended as a warning to plan fiduciaries that are using plan assets for non-economic “social” purposes, to make them aware that there are risks in engaging in such activities.

The new 2008 language uses terminology designed to emphasize the narrow nature of the circumstances that permit consideration of non-economic benefits, requiring that the investment be “truly equal” and “of equal value” to an alternative investment, and warning that to allow otherwise “might compromise or subordinate the interests of plan participants and beneficiaries.” Despite the added language, the basic standard has not changed from the 1994 guidance – namely, that such an investment should not be intended to provide the plan with a lower rate of return than available alternative investments with commensurate risk, or greater risk than alternative investments with commensurate rates of return. The effect of the revised bulletin may be a heightened interest in documenting this type of analysis before entering into investments that are intended to provide non-economic benefits. It may also cause fiduciaries to more properly focus on economic considerations when considering the non-economic aspects of an investment.

Similarly, the revised proxy voting guidance appears intended to discourage shareholder activism, including socially-directed proxy voting, that is designed to promote non-economic interests at the possible expense of a plan’s investment performance. However, what may be the more notable development for investment managers is the additional language on cost-benefit analysis. Subsequent to the DOL guidance on proxy voting in the late 1980s, as codified in the 1994 interpretive bulletin, ERISA plan fiduciaries hiring managers have made a point of requiring that the managers vote proxies on the managed assets and make their proxy voting records available for review, to meet the standards being set by DOL. There were arguments that proxy voting may not be cost effective for certain types of investment funds and strategies, but the DOL position did not appear to take cost considerations into account except with regard to foreign investments. Now, after Interpretive Bulletin 08-2, it is clear that cost considerations can be considered in exercising shareholder rights on domestic investments as well.