The Department of Labor (DOL) Finalizes Two ERISA Fiduciary Regulations Before the Change in Administrations

December 28, 2020

The DOL has amended the regulation defining ERISA’s “standard of care” by adding provisions regarding the “Financial Factors in Selecting Plan Investments” and the “Fiduciary Duties Regarding Proxy Voting and Shareholder Rights”. The Financial Factors provisions change the regulation’s existing safe harbor regarding the prudent selection of investments and added particular actions required for fiduciaries to satisfy their duty of loyalty. This amendment is generally effective for investments decisions made after January 12, 2021. The Proxy Voting provisions set forth the requirements for fiduciaries when exercising shareholder rights or retaining proxy voting services, and provides a safe harbor for proxy voting policies that set parameters on which proxies will be voted. This amendment is generally effective when exercising shareholder rights after January 16, 2021.

Financial Factors – Prudence: Since 1979, the regulation under ERISA Section 404, the “Investment Duties” regulation, described how fiduciaries can satisfy their duty of prudence when carrying out investment activities. The regulation provides a safe harbor if a fiduciary:

  • determines that a particular investment is reasonably designed as part of the portfolio to further the plan’s purposes, after weighing the investment’s associated risk of loss and opportunity for gain (or other return); and
  • considers the portfolio’s diversification, liquidity and current return relative to the plan’s anticipated cash flow needs, as well as the portfolio’s projected return relative to the plan’s funding objectives.

The Financial Factors amendment adds a new requirement to the safe harbor:

  • a fiduciary must compare the investment’s opportunity for gain with that of other reasonably available investment alternatives with similar risks.

The preamble to this amendment notes that the regulation does not require that fiduciaries “scour the market or consider every possible alternative”.

Financial Factors – Loyalty: The Financial Factors amendment also adds new provisions on what fiduciaries must do to satisfy their ERISA duty of loyalty when selecting plan investments. Unlike the prudence rules, the new duty of loyalty provisions are not safe harbors but rather minimum standards. The regulation requires that, except in limited circumstances, fiduciaries must base investment decisions only on pecuniary factors. The regulation defines a pecuniary factor as one that the fiduciary determines will likely have a material effect on an investment’s return and/or risk, based on appropriate investment horizons, and consistent with the plan’s investment objectives.

The regulation reiterates the DOL’s longstanding position that fiduciaries may not subordinate participants’ interests in retirement income, sacrifice investment return or take on additional risk to promote any “nonpecuniary” goals. Although the proposed regulation focused on environmental, social or corporate governance (ESG)-based decision-making, the final regulation removed particular reference to ESG factors in favor of the more general “nonpecuniary goals” language outlined herein.

The preamble to the Financial Factors regulation contained several important points:

  • The DOL’s view is that fiduciaries should easily be able to determine whether nonpecuniary factors are a material part of a fund’s investment objectives by reviewing an investment alternative’s prospectus or similar document.
  • The DOL cautioned against (but did not explicitly prohibit) selecting investment alternatives or utilizing investment strategies that screen companies based on nonpecuniary factors; examples of such screening include excluding companies that produce weapons or fossil fuels, or including only companies that meet certain carbon emission or board diversity criteria. The DOL believes screening raises the possibility that the investment alternative or strategy is forgoing financial returns to further nonpecuniary goals.
  • In response to comments that the proposed regulation could deter fiduciaries from engaging in common, accepted and generally beneficial practices, such as the use of proprietary products, the preamble clarified that the final rule neither prohibits nor permits these practices, but reiterated that fiduciaries must evaluate whether such practices are expected to have a material effect on risk and/or return compared with reasonably available alternatives.

Proxy Voting: The Proxy Voting regulation delineates the obligations of fiduciaries when exercising shareholder rights, including whether or not to vote and the utilization of proxy advisory firms. In order to meet their prudence and loyalty duties under Section 404 of ERISA, plan fiduciaries must:

  • act solely in accordance with the economic interest of the plan and its participants and beneficiaries;
  • consider any costs involved;
  • not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to any non-pecuniary objective;
  • not promote non-pecuniary benefits or goals unrelated to those financial interests of the plan’s participants and beneficiaries or the purposes of the plan;
  • evaluate material facts that form the basis for any particular proxy vote or other exercise of shareholder rights;
  • maintain records on proxy voting activities and other exercises of shareholder rights; and
  • exercise prudence and diligence in the selection and monitoring of persons, if any, selected to advise or otherwise assist with the exercise of shareholder rights, such as parties who provide research and analysis, recommendations regarding proxy votes, administrative services with voting proxies, or recordkeeping and reporting services.

The Proxy Voting provisions include two safe harbors for decisions on whether or not to vote proxies. Fiduciaries may adopt either, or both, of the following policies:

  • a policy of voting only on particular types of proposals that the fiduciary has prudently determined are substantially related to the corporation’s business activities or are expected to have a material effect on the value of the investment; and/or
  • a policy of refraining from voting on proposals or types of proposals when the size of the holding is below quantitative thresholds that the fiduciary prudently determines, considering the percentage ownership of the stock and other relevant factors, is sufficiently small that the matter being voted upon is not expected to have a material effect on the investment performance of the portfolio.

Legal Challenges: Both of these regulations may be subject to legal challenge. In addition, the Biden Administration may choose to revise or interpret these regulations upon entering office. The rulemaking process required for the DOL to revise the current regulations or draft new regulations can take a substantial amount of time and be burdensome on the agency. Alternatively, if Democrats have the necessary votes in Congress they could use the Congressional Review Act to quickly remove these regulations, but history indicates this fast-tracked approach is unlikely. We will continue to monitor these rules and alert our clients to any significant developments.

If you have questions or require further information on these regulations, please contact S. John Ryan at (212) 574-1679, Michael O’Brien at (212) 574-1505, or Bradley Fay at (212) 574-1429.