At the end of June, the U.S. Department of Labor issued guidance relating to the determination of an investment adviser’s fiduciary status under ERISA, as well as the ability of ERISA fiduciaries to take into account economic, social and governance (“ESG”) considerations when making fiduciary investment decisions for ERISA plans, each of which is discussed below.

DOL Proposes New Fiduciary Standard

On June 29, 2020, the DOL issued two forms of guidance relating to its “fiduciary rule,” which defines the types of investment advisory activities that confer ERISA fiduciary status on investment advisers. Please see our previous Client Memoranda, Fifth Circuit Issues Mandate Vacating the DOL Fiduciary Rule, U.S. DOL Releases Final ERISA Fiduciary Rule and ERISA Fiduciary Rule: Some Quick Action Items, for further background regarding the fiduciary rule as in effect from June 2017 until June 2018 (the “2017/2018 Rule”). In short, the new guidance confirms the continued applicability of the so-called “five- part test,” which has generally applied since 1975 (other than the brief period during which the 2017/2018 Rule was in effect).

In addition, the DOL proposed a prohibited transaction class exemption that would permit an ERISA investment advice fiduciary to receive commission-based compensation that would otherwise be prohibited under ERISA, provided that the fiduciary complies with certain standards, as more fully described below.

Discussion

The recent guidance formally implements the Fifth Circuit’s vacatur of the 2017/2018 Rule and reinstates as a final regulation the five-part fiduciary test as it existed before being amended by the 2017/2018 Rule. As noted in our October 2010 and June 2018 Client Memoranda, under the five-part test, a person who provides investment advice to an ERISA plan client for a fee is not considered an ERISA fiduciary unless each of the following five elements is satisfied: (1) the person renders advice as to the value of securities or other property or the advisability of investing in, purchasing or selling securities or other property, (2) on a regular basis, (3) pursuant to a mutual understanding with the plan client that (4) the advice will serve as a primary basis for the plan client’s investment decisions and that (5) the advice will be individualized based on the needs of the plan client.

In addition, the DOL proposed a prohibited transaction class exemption that would permit ERISA investment advice fiduciaries to receive commission-based compensation for the provision of fiduciary investment advice, including rollover recommendations. The class exemption would also permit ERISA investment advice fiduciaries to enter into principal transactions in which the fiduciary could purchase or sell certain securities from its own inventories to or from plan clients. The exemption would be available to registered investment advisers, broker-dealers, insurance companies, banks and individual investment professionals who are their employees or agents (in each case, provided that the fiduciary has not been convicted of certain crimes in connection with the provision of investment advice or egregious conduct with respect to compliance with the exemption). The exemption would, however, require investment advice to be delivered in accordance with a best interest standard, a reasonable compensation standard, a requirement to make no materially misleading statements and certain other protective conditions (including required disclosures to investors, conflict mitigation and annual compliance review).

The DOL has requested written comment by interested persons by July 29, 2020, following which the proposed class exemption will be reviewed and revised by the DOL.

Financial Factors in Selecting Plan Investments

On June 23, 2020, the DOL issued a proposed rule defining an ERISA plan fiduciary’s duty under ERISA when considering investments that incorporate ESG criteria. The proposed rule would amend the regulations under Section 404(a) of ERISA to provide that a plan fiduciary must select “investments and/or investment courses of action based solely on their pecuniary factors and not on the basis of any non-pecuniary factor.”

ERISA and Prior DOL Guidance

ERISA requires plan fiduciaries to act solely in the interest of plan participants and beneficiaries and for the exclusive purpose of providing benefits and paying plan expenses. Over the years, the DOL has issued various forms of guidance with respect to ESG investing, which generally conclude that plan fiduciaries cannot weigh ESG factors more heavily than financial factors when making investment decisions. However, the DOL’s view on the level of importance that plan fiduciaries may assign to ESG factors has shifted back and forth in nuanced ways with changes in Presidential administrations (with Democratic administrations being more supportive of allowing plan fiduciaries to include ESG factors in their investment decision process). Notably, this is the first time that the DOL has sought to issue ESG guidance in the form of notice and comment rulemaking, rather than by Interpretive Bulletin or other less formal means.

Discussion

In the proposed rule, the DOL highlights its concern that a cultural focus on ESG investing could result in investment decisions that are based on factors other than maximizing economic returns for plan participants. The DOL recognizes that certain ESG considerations (e.g., a company’s improper disposal of hazardous materials and dysfunctional corporate governance) may affect an investment’s pecuniary performance and may therefore be taken into account by an ERISA fiduciary only if they “present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories.” In addition, if two investments are “economically indistinguishable,” a plan fiduciary may include ESG factors in its decision process. In the DOL’s view, however, it would be extremely rare for investments to be economically indistinguishable. Under the proposed rule, if an investment is selected based on non-economic factors, fiduciaries should adequately document how two investments are identical and the reasons behind the fiduciary’s ultimate choice of investment.