Risk & Reward

Greetings from Texas USA.

Texas and Maine Approaches to Fossil Fuel Divestment a Cautionary Tale for Investment Managers

State and local governmental plans, which are excluded from ERISA, are subject to idiosyncratic legal requirements, including specific investment restrictions. These plans are also not immune to the political winds blowing in that state. Nowhere is this more apparent than recent developments out of the States of Texas and Maine with respect to fossil fuel divestment. Investment managers of any governmental plan, especially those that take environmental, social and governance (ESG) factors into account, should pay close attention to these developments. Private equity and other fund managers, for the reasons stated below, should also take note.

Texas
On June 14, 2021, Texas Governor Greg Abbott signed into law SB 13. This new law, which goes into effect on September 1, 2021, generally prohibits state governmental entities, including the Employees Retirement System of Texas and the Teacher Retirement System of Texas, from directly or indirectly holding the securities of a publicly-traded financial services, banking or investment company that “boycotts” companies that (i) explore, produce, utilize, transport, sell or manufacture fossil fuel-based energy and (ii) do not “commit or pledge to meet environmental standards beyond applicable federal and state law….” The concept of “boycott” is not limited to divestment; rather, it picks up activity that is designed to inflict economic harm on the energy company. The exercise of certain shareholder rights could possibly amount to a “boycott” of a company.

The law also generally prohibits governmental entities from contracting with a service provider unless the contract provides a written verification from the service provider that it does not boycott energy companies and will not boycott energy companies during the term of the contract. This applies to contracts entered into on or after September 1, 2021.

Fiduciaries of these Texas governmental plans remain subject to countervailing fiduciary duties under Texas law, including the Texas Constitution. The new law crucially allows for breathing space between these core fiduciary duties and the state’s interest in protecting significant portions of its economy.

The law provides that these governmental entities are not required to divest from any holdings in “actively or passively managed investment funds or private equity funds.” However, the governmental entities are required to submit letters to the managers of these funds requesting that they remove from the portfolio financial companies that the state comptroller has designated as boycotting energy companies. The Texas governmental entities will alternatively request that the managers “create a similar actively or passively managed fund with indirect holdings devoid of listed financial companies.” Investment managers should be on the lookout for these letters starting this coming Fall.

Maine
Meanwhile, in Maine, the House of Representatives recently passed a bill that calls for the divestment of fossil fuel companies by the Maine Public Employees Retirement System (Maine PERS) and other permanent state funds by 2026. As with Texas, the law is sensitive to the overriding fiduciary duties that apply to the management of these assets. An official for Maine PERS recently testified that, “[p]ermanently striking broad portions of the financial market is incompatible with earning optimal returns for member retirements, will not change corporate behavior, and may not advance the social goals sought because investments are rarely one dimensional.”

Takeaways
Governmental plans invested in separate accounts or commingled funds managed by an investment manager have always posed risks to that manager, as these plans are subject to their own fiduciary duties and investment restrictions. Though the state laws applicable to governmental plans may contain ERISA-like language, we caution investment managers from relying on ERISA or DOL guidance as a failsafe way to manage governmental plan assets. As evidenced from the disparate approaches the States of Texas and Maine have taken, investment managers should pay close attention to the specific rules applicable to these plans to avoid running afoul of state law. With the calls for fossil fuel divestment growing louder in some quarters, and as other ESG issues come to the fore, careful due diligence on the part of investment managers is essential.

Please contact George Michael Gerstein to discuss these matters or other due diligence issues related to governmental plans.

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Cybersecurity and Related Legal Risks Come Home to ERISA Plans

ERISA-covered plans have entered the digital world. As the amount of confidential information about plan participants that is stored in multiple information systems, and shared among plan service providers, increases, so, too, do the legal risks. The U.S. Department of Labor (DOL) has now made cybersecurity risk an enforcement priority; the courts have started to wrestle with whether participant data is a “plan asset.” Plan sponsors and service providers should brace themselves.

Just this past February, the U.S. Government Accountability Office (GAO) issued a report that highlighted the practice of, and risks related to, sharing personally identifiable information (e.g., a participant’s social security number, date of birth and username/password) (PII), and “plan asset data” (e.g., retirement account and bank account numbers) within the plan ecosystem. The plan sponsor’s own IT infrastructure may be vulnerable to attack or misuse. Where the plan sponsor outsources plan administrative responsibilities to a service provider, such as recordkeepers, third-party administrators and custodians, participant PII and plan asset data could be exploited if the service provider is hacked or lacks appropriate internal controls.

The report specifically noted that cybersecurity risk comes in many different flavors and from many different sources. The risk could, for example, be in the form of malware, ransomware, privilege abuse, data exfiltration and account takeover. The source of the risk could come from criminal syndicates, hackers and even an organization’s own employees.

Thus, the GAO report warned, “[t]he sharing and storing of this information can lead to significant cybersecurity risks for plan sponsors and their service providers, as well as plan participants.” Poor risk controls can lead to the leaking of usernames, passwords and social security numbers, which can lead to the unauthorized access of participant accounts, and, fatally, the illicit draining of a participant’s retirement savings. The misappropriation of participant PII or plan assets by virtue of a cybersecurity attack may not be expressly addressed in ERISA, but its effect on a participant may indeed result in “the great personal tragedy” Congress sought to prevent in enacting ERISA.1

The GAO ultimately made two recommendations: (1) the DOL should formally state whether cybersecurity for ERISA-covered retirement plans is a plan fiduciary responsibility under ERISA; and (2) the DOL should develop and issue guidance that identifies minimum expectations for mitigating cybersecurity risks to plans and the relevant service providers.

A mere two months later, the DOL issued a series of cybersecurity tips and best practices for plan sponsors, service providers and participants. Specifically:

  • Tips for Hiring a Service Provider, to “[h]elp[] plan sponsors and fiduciaries prudently select a service provider with strong cybersecurity practices and monitor their activities, as ERISA requires.”
  • Cybersecurity Program Best Practices, to “[a]ssist[] plan fiduciaries and recordkeepers in their responsibilities to manage cybersecurity risks.”
  • Online Security Tips, to “[o]ffer[] plan participants and beneficiaries who check their retirement accounts online basic rules to reduce the risk of fraud and loss.”

Useful as the tips and practices may be, the big reveal is that the DOL indicated that ERISA’s duty of prudence encompasses “an obligation to ensure proper mitigation of cybersecurity risks.” This means that a responsible plan fiduciary, when determining whether to hire and retain a service provider, should consider the service provider’s cybersecurity risk controls, and should document such consideration as part of its overall evaluation of the service provider.

The upshot of the DOL’s April 2021 cybersecurity tips and best practices is that it puts employers on notice that both the DOL takes this seriously and that plaintiffs could attempt to use this new guidance as a basis for fiduciary duty breach claims. Moreover, service providers can expect detailed questions on cybersecurity in RFPs and RFIs. Plan sponsors will seek more transparency, whereas service providers may be reluctant to divulge too much on their cybersecurity defenses to guard against inadvertently offering up the keys to the castle. The balance of the two will become market practice.

The DOL is ramping up enforcement in this area. Plan sponsors should also gird for class-action lawsuits with allegations of breaches of ERISA’s duty of prudence when participant PII or plan asset data is misused. For these reasons, employers and plan service providers should carefully consider the DOL guidance.

A related string of litigation also poses a risk to plan sponsors and service providers. These suits argue that participant PII and plan asset data constitute “plan assets,” and that using such data for marketing purposes amounts to a breach of fiduciary duties. Some of these suits have targeted both the plan’s sponsor and recordkeeper. So far, the courts have rejected these claims.

In one case,2 plaintiffs brought an action against the plan sponsor and recordkeeper alleging that participant data (e.g., names, contact info, investment history, etc.) constituted “plan assets,” and, therefore, the recordkeeper’s purported sharing of this information with affiliates to cross-sell non-plan retail financial products to participants amounted to violations of ERISA. In granting the recordkeeper’s motion to dismiss, the court ruled that “participant data does not meet the statutory definition of ‘plan assets’….”

In a similar case,3 plaintiffs brought suit against the plan administrator alleging, inter alia, breach of fiduciary duty over the plan’s recordkeeper access to participant information (e.g., investment choice, account size, etc.and use of that data to market products to the participants. In granting the motion to dismiss, the court stated, “[p]laintiffs cite no case in which a court has held that such information is a plan asset for purposes of ERISA….[t]his Court does not intend to be the first.” Moreover, the court rejected the argument that “releasing confidential information or allowing someone to use confidential information constitutes a breach of fiduciary duty under ERISA.”

Cybersecurity is quickly becoming an important risk area for ERISA plan sponsors. Protection of participant PII and plan asset data against privilege abuse, account takeovers and other vulnerabilities to a participant’s information and account raises the specter for DOL enforcement action and litigation. Service providers should anticipate a greater focus on their cybersecurity measures by plan sponsors and expect that such measures could be an important basis to be hired and retained as a plan service provider. Both employers and plan service providers should also consider whether it is complying with other applicable privacy laws (to the extent such laws are not preempted by ERISA).

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1 Nachman Corp. v. PBGC, 446 U.S. 359, 374, 100 S. Ct. 1723, 1733, 64 L. Ed. 2d 354, 366 (1980).
2 Harmon v. Shell Oil Co., No. 3:20-cv-00021, 2021 BL 126207 (S.D. Tex. Mar. 30, 2021).
3 Divane v. Northwestern Univ., No. 16 C 8157, 2018 BL 186065 (N.D. Ill. May 25, 2018), aff’d, 953 F.3d 980 (7th Cir. 2020).

Significant ESG Movement on the ERISA Front

Legislation is afoot that would amend ERISA to expressly permit fiduciaries to account for environmental, social and governance (ESG) factors as part of their fiduciary duties. The proposed legislation, the Financial Factors in Selecting Retirement Plan Investments Act, was introduced by Senator Tina Smith (D-MN). It expressly permits, but does not compel, fiduciaries to “consider” ESG and similar factors when selecting investments or strategies on behalf of an ERISA-covered retirement plan. The legislation also permits fiduciaries to consider “collateral” factors “as tie-breakers when competing investments can reasonably be expected to serve the plan’s economic interest equally well with respect to expected return and risk over the appropriate time horizon.” Under either scenario, the fiduciary need not “maintain any greater documentation, substantiation, or other justification” when considering the ESG or similar factors. Notably, the bill provides that an investment selected based on ESG or similar factors (including such factors used as a tie-breaker) may be a permissible default investment option (a “qualified default investment alternative” (QDIA)) for a plan that uses a default investment option as part of its menu. Lastly, the US Department of Labor’s (DOL) 2020 Financial Factors rule would cease to have force or effect upon the enactment of the legislation.

Meanwhile, President Joe Biden just issued an Executive Order on Climate-Related Financial Risk, in which he directed the DOL to consider proposing by September 2021 a rule that would suspend, revise or rescind the Financial Factors and proxy voting rules promulgated under the Trump Administration. The Executive Order further directed the DOL to consider taking any other action under ERISA “to protect the life savings and pensions of United States workers and families from the threats of climate-related financial risk.”

Should the legislation pass, it could provide fiduciaries limited additional comfort that the incorporation of ESG factors in their investment decision-making complies with ERISA’s fiduciary duties. The trend is toward incorporating ESG factors into an investment process for their effect on investment performance, and existing guidance, including the Financial Factors rule, should already provide fiduciaries enough of a roadmap to do so in accordance with ERISA. The legislation also seeks to dial back the documentation requirements of the Financial Factors rule, which may indeed ease some of the angst over foot faults and the resulting liability exposure. Though the DOL removed all references to “ESG” in the final Financial Factors rule, some argued the rule’s aggressive proposal, coupled with the Trump Administration’s overall stance on climate change, was designed to curb ERISA fiduciaries’ appetite for ESG. Yet, carefully documenting important decisions is already a well-established requirement and technique used by fiduciaries to mitigate their fiduciary duty risk.

It is a big deal that, with a rescission of the Financial Factors rule, fiduciaries would seemingly no longer have to comb through a fund’s prospectus and marketing materials for references to non-pecuniary factors, nor would the fiduciary need to scrutinize a fund manager’s use of screens or ratings. These requirements obviously present legal risk to a fiduciary and, therefore, may deter some fiduciaries from considering ESG products. But they also may serve as useful guideposts for fiduciaries trying to avoid selecting a greenwashed fund. An unintended consequence of the legislation could be that stripping out specific actions a fiduciary must take to navigate the intricate ESG landscape perhaps deters more plan sponsors from adding ESG to their plans than if the guideposts (and associated legal risks) remained.

It is also a big deal that the proposed legislation would allow a fund, which incorporates ESG factors for non-investment performance reasons, to serve as QDIA. The Financial Factors rule outright prohibited such a result. This change will likely give some plan sponsors comfort in selecting an ESG-themed QDIA that does not base ESG decisions on risk and return criteria, for example. However, the zealous litigation routinely brought against defined contribution plan sponsors over the selection of investment options has largely resulted in playing it safe. Plan sponsors know they will be second-guessed. This change, therefore, is unlikely to dramatically increase the adoption of ESG by ERISA plans, which continue to lag other institutional investors on that score.

The Executive Order is worth watching. The DOL may opt to impose affirmative obligations on fiduciaries to mitigate climate change risk to the plan. The imposition of any such obligation will likely be litigated.

In sum, ESG is and will remain entirely relevant to ERISA fiduciaries. Under ERISA and existing guidance, fiduciaries may take ESG factors into account when investing plan assets or selecting investment options for a plan lineup. With ESG top of mind for the current Congress and White House, ERISA fiduciaries should continue to evaluate whether taking ESG into account is prudent under the circumstances.

Springtime DOL Updates

By George Michael Gerstein and John “JJ” Dikmak Jr.

As we await even more fiduciary-related rules and guidance from the U.S. Department of Labor (DOL) over the coming months, we take stock of some lower-profile spring updates worth noting. We begin with the DOL’s recent cybersecurity guidance, the first of its kind, as cybersecurity becomes an increasingly important issue for plan sponsors and service providers. We conclude with some new DOL guidance related to locating missing plan participants.

Cybersecurity

On April 14, the DOL released a batch of guidance that attempts to clarify best practices for maintaining cybersecurity. The first of the guidance, aimed at plan sponsors and other fiduciaries, offers tips for hiring third-party service providers and ensuring they maintain strong cybersecurity practices. The second batch of guidance offers cybersecurity best practices for plan recordkeepers and plan fiduciaries. A final release offered tips for plan participants who access their account information online but will not be discussed here. These are the first cybersecurity guidance provided by the DOL.

The following tips offered by the DOL are designed to help fiduciaries meet their obligations under ERISA in prudently selecting and monitoring service providers:

  1. Ask about the service provider’s information security standards, practices, policies, and audit results and compare them to industry standards.
  2. Ask the service provider how it validates its practices and what levels of security standards it has met and implemented. Consider looking at contract provisions that confer rights to review audit results demonstrating compliance with the standards.
  3. Evaluate the track record of the service provider, including litigation brought against the service provider.
  4. Ask if the service provider has experienced security breaches and, if so, what happened, how the provider responded, and how it was resolved.
  5. Inquire if the service provider has insurance that would cover losses caused by cybersecurity and identity theft breaches.
  6. Include ongoing compliance with cybersecurity and information security standards as a part of the service provider’s contractual commitments. If possible, include terms that will enhance these protections, such as:

a. Require the service provider to obtain an annual audit from a third-party to evaluate the service provider’s compliance with information security policies and procedures.

b. Clearly stated provisions outlining the service provider’s obligations and restrictions on the use and sharing of information.

c. Require notification of any cybersecurity breaches.

d. Specific requirement to meet all federal, state and local laws, regulations, directives and requirements related to record retention, destruction, privacy, and security.

e. Required insurance to cover losses related to cybersecurity losses. This may include professional liability, errors and omissions liability, cyber liability, and/or privacy breach insurance.

In the second batch of guidance, the DOL offered best practices for plan recordkeepers and other service providers responsible for plan-related data. The list also includes the best practices for a plan fiduciary hiring one of these service providers. These best practices include:

  1. Have a formal, well-documented cybersecurity program. DOL highlighted 18 specific areas an effective policy would cover, including data governance and classification, access controls and identity management, business continuity and disaster recovery, configuration management, asset management, and risk assessment.
  2. Conduct prudent annual risk assessments. The scope, methodology, and frequency of assessments should be codified.
  3. Have a reliable annual third-party audit of security controls.
  4. Clearly define and assign information security roles and responsibilities. This includes clearly defining the roles of upper management, especially the Chief Information Security Officer (CISO).
  5. Have strong access control procedures which cover both authentication and authorization.
  6. Ensure that any assets or data stored in a cloud or managed by a third-party service provider are subject to appropriate security reviews and independent security assessments.
  7. Perform cybersecurity awareness training at least annually.
  8. Implement and manage a secure system development life cycle (SDLC) program.
  9. Have an effective business resiliency program addressing business continuity, disaster recovery, and incident response.
  10. Encrypt sensitive data, stored and in transit.
  11. Implement strong technical controls in accordance with best security practices.
  12. Appropriately respond to any past cybersecurity incidents. This would include notifying law enforcement, informing insurers, investigations, providing plan participants with information to assist in preventing or reducing their loss, honoring contractual terms, such as notification requirements, and fixing the problems which caused the breach.

Missing Participants

Earlier this year, the DOL provided a set of best practices for fiduciaries of defined benefit and defined contribution plans to locate missing participants and beneficiaries. Some “red flags” that a plan’s current approach may be insufficient for locating a missing or non-responsive participant include a large number of missing or non-responsive participants; missing, incomplete or inaccurate contact and other pertinent information (email, social security numbers, addresses, etc.), and the absence of adequate policies and procedures for handling returned mail marked “return to sender,” “wrong address” and the like.

The DOL’s list of best practices (copied below) are those that “have proven effective at minimizing and mitigating the problem of missing or non-responsive participants.” These practices are non-exhaustive, and some may be more appropriate for a particular plan than others. Ultimately, “[r]esponsible plan fiduciaries should consider what practices will yield the best results in a cost-effective manner for their plan’s particular participant population.”

1. Maintaining accurate census information for the plan’s participant population

  • Contacting participants, both current and retired, and beneficiaries on a periodic basis to confirm or update their contact information. Relevant contact information could include home and business addresses, telephone numbers (including cell phone numbers), social media contact information, and next of kin/emergency contact information. Well-run plans regularly reconfirm that the information in their possession is accurate.
  • Including contact information change requests in plan communications along with a reminder to advise the plan of any changes in contact information.
  • Flagging undeliverable mail/email and uncashed checks for follow-up.
  • Maintaining and monitoring an online platform for the plan that participants can use to update contact information for themselves and their spouses/beneficiaries, if any, and incorporating such updates into the plan’s census information.
  • Providing prompts for participants and beneficiaries to confirm contact information upon login to online platforms.
  • Regularly requesting updates to contact information for beneficiaries, if any.
  • Regularly auditing census information and correcting data errors.
  • In the case of a change in record keepers or a business merger or acquisition by the plan sponsor, addressing the transfer of appropriate plan information (including participant and beneficiary contact information) and relevant employment records (e.g., next of kin information and emergency contacts). [DOL] has found that in the context of an acquisition, merger, or divestiture, well-run plans make missing participant searches of plan, related plan (e.g., health plan) and employer records (e.g., payroll records) part of the collection and transfer of records.

2. Implementing effective communication strategies

  • Using plain language and offering non-English language assistance when and where appropriate.
  • Stating upfront and prominently what the communication is about – e.g., eligibility to start payment of pension benefits, a request for updated contact information, etc.
  • Encouraging contact through plan/plan sponsor websites and toll-free numbers.
  • Building steps into the employer and plan onboarding and enrollment processes for new employees, and exit processes for separating or retiring employees, to confirm or update contact information, confirm information needed to determine when benefits are due and to correctly calculate the amount of benefits owed, and advise employees of the importance of ensuring that the plan has accurate contact information at all times.
  • Communicating information about how the plan can help eligible employees consolidate accounts from prior employer plans or rollover IRAs.
  • Clearly marking envelopes and correspondence with the original plan or sponsor name for participants who separated before the plan or sponsor name changed, for example, during a corporate merger, and indicating that the communication relates to pension benefit rights.

3. Missing participant searches

  • Checking related plan and employer records for participant, beneficiary and next of kin/emergency contact information. While the plan may not possess current contact information, it is possible that the employer’s payroll records or the records maintained by another of the employer’s plans, such as a group health plan, may have more up-to-date information. If there are privacy concerns, the person engaged in the search can request that the employer or other plan fiduciary forward a letter from the plan to the missing participant or beneficiary.
  • Checking with designated plan beneficiaries (e.g., spouse, children) and the employee’s emergency contacts (in the employer’s records) for updated contact information; if there are privacy concerns, asking the designated beneficiary or emergency contact to forward a letter to the missing participant or beneficiary.
  • Using free online search engines, public record databases (such as those for licenses, mortgages and real estate taxes), obituaries, and social media to locate individuals.
  • Using a commercial locator service, a credit-reporting agency, or a proprietary internet search tool to locate individuals.
  • Attempting contact via United States Postal Service (USPS) certified mail, or private delivery service with similar tracking features if less expensive than USPS certified mail, to the last known mailing address.
  • Attempting contact via other available means such as email addresses, telephone and text numbers, and social media.
  • If participants are non-responsive over a period of time, using death searches (e.g., Social Security Death Index) as a check and, to the extent such search confirms a participant’s death, redirecting communications to beneficiaries.
  • Reaching out to the colleagues of missing participants by, for example, contacting employees who worked in the same office (e.g., a small employer with one or two locations) or by publishing a list of “missing” participants on the company’s intranet, in email notices to existing employees, or in communications with other retirees who are already receiving benefits. Similarly, for unionized employees, some have reached out to the union’s local offices and through union member communications to find missing retirees.
  • Registering missing participants on public and private pension registries with privacy and cybersecurity protections (e.g., National Registry of Unclaimed Retirement Benefits), and publicizing the registry through emails, newsletters, and other communications to existing employees, union members, and retirees.
  • Searching regularly using some or all of the above steps.

4. Documenting procedures and actions

  • Reducing the plan’s policies and procedures to writing to ensure they are clear and result in consistent practices.
  • Documenting key decisions and the steps and actions taken to implement the policies.
  • For plans that use third party record keepers to maintain plan records and handle participant communications, ensuring the record keeper is performing agreed-upon services, and working with the record keeper to identify and correct shortcomings in the plan’s recordkeeping and communication practices, including establishing procedures for obtaining relevant information held by the employer.

DOL Issues Guidance on 2020 Investment Advice Exemption

By George Michael Gerstein and John “JJ” Dikmak Jr.

Just yesterday, the U.S. Department of Labor (“DOL”) released a set of Frequently Asked Questions (“FAQs”) designed to clarify certain aspects of Prohibited Transaction Exemption 2020-02, Improving Investment Advice for Workers & Retirees (PTE 2020-02). The exemption enables investment advice fiduciaries to ERISA plans and IRAs to receive a wide range of compensation (e.g., commissions, 12b-1 fees, revenue sharing, etc.) as a result of the advice without running afoul of the applicable prohibited transaction rules. As described by the DOL, “[t]he exemption offers a compliance option to investment advisers, broker-dealers, banks, and insurance companies (financial institutions) and their employees, agents, and representatives (investment professionals) that is broader and more flexible than pre-existing prohibited transaction exemptions.” We summarize some of the key takeaways from the FAQs below:

  • PTE 2020-02 is in effect (February 16, 2021). There was some confusion over this due to a memorandum from Ronald Klain, Chief of Staff to the President, regarding a regulatory freeze. The (new) DOL, however, was pleased enough with PTE 2020-02, a Trump-era rulemaking, that it waved it through. The transition period for parties to devise mechanisms to comply with the provisions in the exemption remains in place until December 20, 2021.
  • The DOL hinted at further sub-regulatory guidance and/or returning to the fiduciary investment advice regulation. No promises were made or timetables offered.
  • The DOL reiterated that a “single, discrete instance of advice to roll over assets from an employee benefit plan to an IRA” would generally not give rise to investment advice under ERISA. But, such communication could constitute investment advice if it were part of an ongoing relationship or the beginning of an intended future ongoing relationship that an individual has with the investment advice provider.
  • The DOL reminded the industry that boilerplate, fine print disclaimers that investment advice is not being provided generally won’t cut it. This echoes sentiment the DOL expressed in 2020. However, “[w]ritten statements disclaiming a “mutual” understanding or forbidding reliance on the advice as “a primary basis for investment decisions” may be considered in determining whether a mutual understanding exists, but such statements will not be determinative.” Ultimately, whether there is a “mutual” understanding that investment advice is being provided is based on the totality of the facts and circumstances.
  • The DOL reiterated that PTE 2020-02 provides relief for rollover recommendations that result in a prohibited transaction, so long as the exemption’s conditions are satisfied.
  • Investment professionals and financial institutions can provide investment advice, despite having a financial interest in the transaction, as long as the advice meets the best interest standard. Under this standard, the advice must be based on the interests of the customer, rather than the competing financial interest of the investment professional or financial institution. Investment professionals may receive payments for their advice within this framework.
  • Prior to engaging in a transaction under the exemption, a financial institution must give the retirement investor a written description of its material conflicts of interest arising out of the services and any investment recommendation. The disclosure should allow a reasonable person to assess the scope and severity of the financial institution’s and investment professional’s conflicts of interest.  The DOL cautioned that the disclosure should be more than simply having the retirement investor “check the box” to confirm that they know of the conflicts.
  • Financial institutions and their investment professionals need to consider and document their analysis of why a rollover recommendation is in a retirement investor’s best interest. For recommendations to roll over assets from an employee benefit plan to an IRA, the DOL listed the following “relevant” non-exhaustive factors to consider: (1) the alternatives to a rollover, including leaving the money in the investor’s employer’s plan, if permitted; (2) the fees and expenses associated with both the plan and the IRA; (3) whether the employer pays for some or all of the plan’s administrative expenses; and (4) the different levels of services and investments available under the plan and the IRA. The DOL also elaborated on what other factors would be part of a prudent analysis.
  • The DOL reminded financial institutions that they “must take special care in developing and monitoring compensation systems to ensure that their investment professionals satisfy the fundamental obligation to provide advice that is in the retirement investor’s best interest.” With carefully considered compensation structures, financial institutions can avoid structures that a reasonable person would view as creating incentives for investment professionals to place their interests ahead of the interest of the retirement investor. Thus, quotas, bonuses, prizes and performance standards are likely out. On the flip side, a financial institution could provide level compensation for recommendations to invest in assets that fall within reasonably defined investment categories (e.g., mutual funds), and provide heightened supervision as between investment categories (e.g., between mutual funds and fixed annuities), to the extent that it is not possible for the institution to eliminate conflicts of interest between these categories. The DOL also reminded financial institutions that the exemption requires they address and mitigate firm-wide conflicts.
  • Unlike the 2016 rulemaking, PTE 2020-02 does not impose contract or warranty requirements on the financial institutions or investment professionals responsible for compliance. Nor does the exemption expand an investors’ ability to enforce their rights in court or create any new legal claims beyond those in Title I of ERISA and the Code.

Financial institutions seeking additional information about their obligations under PTE 2020-02 may consider our initial analysis on PTE 2020-02 and its related rulemaking.

Are You Sure You Can Use the QPAM Exemption?

For many investment managers, the ability to act as “QPAM” is essential to managing retirement account assets. Indeed, status as a QPAM likely provides a sort of credentialing boost in the eyes of prospective plan clients and, more importantly, signals the investment manager’s ability to rely upon the “QPAM Exemption,” a highly versatile exemption used to cure various prohibited transactions under ERISA and Section 4975 of the Internal Revenue Code when it exercises discretion over plan assets. To be a QPAM, however, is not tantamount to satisfying the QPAM Exemption. Moreover, the QPAM Exemption itself is subject to myriad conditions, the failure to meet only one of which can wreak havoc on a compliance strategy. Here, we provide an overview and highlight potential trap doors in a Q&A format.

What is a QPAM?

A QPAM is a “qualified professional asset manager” within the meaning of Part VI(a) of the QPAM Exemption (Prohibited Transaction Class Exemption 84-14). An investment adviser registered under the Advisers Act, for example, is generally eligible to be a QPAM, provided it has total client assets under management of more than $85 million as of the last day of its most recent fiscal year and more than $1 million in shareholders’ or partners’ equity. Thus, newly formed investment managers may need to rely on an alternative exemption for trading, such as Section 408(b)(17) of ERISA, during its first year of operations.

What is the QPAM Exemption, and why is it important?

Fiduciaries of employee benefit plans subject to Title I of ERISA and plans subject to Section 4975 of the Internal Revenue Code (e.g., IRAs) must avoid entering into prohibited transactions for which no exemption is available. A prohibited transaction includes the purchase and sale of securities or other property to a “party in interest.” For example, a swap transaction with a bank would be a prohibited transaction if the bank is a party in interest to the plan client. Virtually all financial service firms will assume they are a party in interest. This is why nearly all ISDA Schedules will include representations from the investment manager that the QPAM Exemption will be met with respect to the transactions. Simply, an investment manager may be hard-pressed to enter into many types of transactions on behalf of plan clients without representing that it can satisfy the QPAM Exemption (while the bank-counterparty in this example may seek a representation from the investment manager that it is a QPAM, the bank would only be interested in knowing that in the context of ensuring the QPAM Exemption can otherwise be met).

To be fair, the QPAM Exemption is not the only game in town. It is, however, a tried and true exemptive approach that facilitates many types of trades an investment manager may want to conduct on behalf of a plan client. Reliance on alternative exemptions may be feasible from a legal standpoint but nevertheless could slow negotiations down. Practically speaking, then, it is important for most investment managers who have discretionary responsibility over plan assets to become familiar with the nuances of the QPAM Exemption and ultimately comply with it.

For purposes of the prohibited transaction rules, is it enough to be a QPAM?

An investment manager’s status as a QPAM is important, but only insofar as the rest of the QPAM Exemption can also be satisfied. In other words, the QPAM Exemption contains several conditions; to meet the definition of a QPAM itself is but one condition.

What are the other conditions of the QPAM Exemption?

Here is an overview of the other key conditions of the QPAM Exemption:

  1. The investment manager (i.e., the QPAM) acknowledges in writing that it is a fiduciary to the plan client.
  2. The entity appointing the QPAM (or entering into the investment management agreement with the QPAM) is not the counterparty (or affiliate) with respect to the transaction. There is a useful exception to this condition for commingled investment funds where no plan (or plans established by the same employer) holds a 10 percent or more interest in the fund.
  3. The counterparty is not the QPAM or otherwise related to the QPAM (i.e., the QPAM Exemption does not cover self-dealing prohibited transaction issues).
  4. No plan, when combined with the assets of other plans established by the same employer, represents more than 20 percent of the QPAM’s total client assets under management.
  5. The terms of the transaction are negotiated by the QPAM, and the QPAM makes the decision to enter into the transaction on behalf of the plan.
  6. The terms of the transaction are at least as favorable to the plan as the terms generally available in an arm’s length transaction between unrelated parties.
  7. Neither the QPAM, any affiliate, nor certain other persons have been convicted of certain U.S. or non-U.S. crimes (e.g., larceny, forgery, theft, counterfeiting, etc.) within the past 10 years. This condition has proven challenging for some large financial services firms with affiliates around the globe that may have been convicted of non-U.S. crimes.

Each and every one of these conditions have to be met.

How should an investment manager proceed?

As evident from the conditions outlined above, the QPAM Exemption cannot be put on autopilot. Investment managers should be cognizant that satisfaction of the QPAM Exemption needs to be battle-tested prior to making a contractual representation to a client or a counterparty that the exemption can be complied with by the investment manager. Investment managers should also be sensitive to the fact that some clients of theirs may conflate an investment manager’s status as a QPAM with the investment manager’s ability to satisfy the QPAM Exemption. Should this occur, both parties may have a false sense of security that the QPAM Exemption can be met for the investment mandate. The existence of non-exempt prohibited transactions by an investment manager can result in severe monetary penalties and reputational harm. If the QPAM Exemption is unavailable for some reason, one or more alternative exemptions may be available, though they should be evaluated prior to entering into the investment management agreement and any trading.

DOL to Revisit Trump ESG-Related Rules

By George Michael Gerstein and John “JJ” Dikmak Jr.

On March 10, the U.S. Department of Labor (DOL) announced that until further notice, it will not enforce certain final rules published at the tail-end of the Trump administration. Specifically, the DOL will revisit, and, in the interim, will cease to enforce, the “Financial Factors in Selecting Plan Investments” and “Fiduciary Duties Regarding Proxy Voting and Shareholder Rights” rules which were published in November and December of 2020, respectively. These rules created requirements for plan fiduciaries subject to the U.S. Employee Retirement Income Security Act of 1974 (ERISA) to consider only pecuniary interests when selecting investments and exercising voting rights. Though the rules certainly cover environmental, social and/or governance (ESG)-driven investment decisions, proxy votes and the exercise of other shareholder rights, all ERISA fiduciaries, regardless of strategy, are subject to the rules. Please note that the rules have not been rescinded. Fiduciaries, therefore, may remain subject to private litigation risk for lack of compliance.

Some have expressed concern that the Financial Factors rule effectively prohibited the use of ESG factors by ERISA fiduciaries. We disagree. ERISA fiduciaries that treat one or more E, S and or/G factors as material to investment performance may continue to do so both under ERISA itself and under the Financial Factors rule, provided the fiduciary follows a prudent process and can point to some data or other evidence that forms the fiduciary’s belief that such factor is an important risk/return consideration, and as otherwise specified under the rule. ESG integration is one such example. The Financial Factors rule also largely retained the longstanding separate DOL test that had to be met in order for an ESG factor to be selected for non-investment performance reasons.

Fiduciaries wishing to proceed with ESG integration may continue to do so without undue risk, provided they follow the core principles and requirements under ERISA, as largely reflected in the Financial Factors rule. Please consider our prior analysis of the Financial Factors rule and the Proxy Voting rule.

DOL’s Optical Illusion – Fiduciary Investment Advice Status

The U.S. Department of Labor (DOL) has reinstated the five-part test for when one becomes a fiduciary to retirement investors (e.g., ERISA plan sponsors, participants, IRA owners, etc.) by reason of giving non-discretionary investment advice. While at first blush the reinstatement seems to offer great relief to various financial institutions that were possibly ensnared under the DOL’s tricky 2016 conflicts of interest rule, private fund sponsors, broker-dealers and investment advisers should proceed with caution. Interpretations by the DOL over the second half of 2020 suggests it will liberally interpret (and enforce) the five-part test for when one becomes an investment advice fiduciary. Tellingly, that the Trump administration opted to expansively interpret the five-part test to the point that it has more than a passing resemblance of the 2016 conflicts of interest rule under the Obama administration suggests that, regardless of which party controls the Executive Branch, the risks of becoming a fiduciary have increased and the opportunities to avoid such status have inexorably winnowed.

Under the test, a person provides “investment advice” if he or she: (1) renders advice to a plan as to the value of securities or other property, or makes recommendations as to the advisability of investing in, purchasing, or selling securities or other property; (2) on a regular basis; (3) pursuant to a mutual understanding; (4) that such advice will be a primary basis for investment decisions; and that (5) the advice will be individualized to the plan. In addition to satisfying the five-part test, a person must also receive a fee or other compensation to be an investment advice fiduciary.

All five conditions of the test must be satisfied, plus the receipt of compensation (direct or indirect), for there to be fiduciary investment advice.

The linchpin is that, in order to be an investment advice fiduciary, the financial institution must receive a direct or indirect fee or other compensation incident to the transaction in which investment advice has been provided, in addition to satisfying the 5-part test. The DOL reiterated its longstanding position that this requirement broadly covers all fees or other compensation incident to the transaction in which the investment advice to the plan has been rendered or will be rendered. This could include, for example, an explicit fee or compensation for the advice that is received by the adviser (or by an affiliate) from any source, as well as any other fee or compensation received from any source in connection with or as a result of, the recommended transaction or service (e.g., commissions, loads, finder’s fees, revenue sharing payments, shareholder servicing fees, marketing or distribution fees, underwriting compensation, payments to firms in return for shelf space, recruitment compensation, gifts and gratuities, and expense reimbursements, etc.).

Condition #1: “renders advice to a plan as to the value of securities or other property, or makes recommendations as to the advisability of investing in, purchasing, or selling securities or other property”

The DOL appears to interpret “securities or other property” broadly to include not only recommendations of specific investments but also any recommendation that would change fees and services that affect the return on investments. This means:

  • A recommendation of a specific security or fund would meet this requirement.
  • A recommendation of a third-party investment advice provider (likely both non-discretionary discretionary, though this is not clear) would meet this requirement.
  • A recommendation of one’s own products or services, which is accompanied by an investment recommendation, such as a recommendation to invest in a particular fund or security, would meet this requirement.1
  • A recommendation to switch from one account type to another (e.g., brokerage vs. advisory, commission-based to fee-based) would meet this requirement.
  • A recommendation of a third party who provides investment advice for which a referral fee is paid would most likely meet this requirement.
  • A recommendation to take a distribution/rollover from a plan into an IRA or from one IRA to another IRA would most likely meet this requirement.2
  • A recommendation of an investment strategy/policy or portfolio composition may meet this requirement.

But some communications will not, without more, give rise to a “recommendation” under prong #1. These include:

  • Marketing one’s products and services.3
  • Investment education, such as information on general financial and investment concepts, (e.g., risk and return, diversification, dollar-cost averaging, compounded return, and tax deferred investment).
  • Simply describing the attributes and features of an investment product.

Condition #2: “on a regular basis”

Looks can be deceiving, and that is certainly the case with the “regular basis” requirement. While it would appear to be self-evident, the DOL’s expansive view of this condition should cause service providers to tread carefully. This is because:

  • A one-time sales transaction that is a recommendation would be on a “regular basis” if it were deemed part of an existing or future investment advice relationship with the retirement investor or there is otherwise an expectation by the investor that the sales communication is part of an investment advice arrangement.
  • An investment recommendation would be on a “regular basis” if it were made on a recurring and non-sporadic basis, and recommendations are expected to continue. Advice need not be provided at fixed intervals to be on a “regular basis.”
  • A rollover recommendation to a participant who has previously received investment advice from the financial institution would be on a “regular basis.”
  • One-time investment advice to a plan sponsor of an ERISA plan, when the financial institution has provided the plan sponsor investment advice with respect to its other ERISA plans, would be on a “regular basis.”

On the other hand:

  • Sporadic or one-off communications are unlikely to be considered on a “regular basis.”

Conditions #3 and #4: “pursuant to a mutual understanding” “that such advice will be a primary basis for investment decisions”

Whether there is a mutual understanding between the parties that communications are—or are not—investment advice turns on the contractual terms and the surrounding facts and circumstances. Here are some markers:

  • Does the written agreement expressly provide for investment advice, or does it expressly and clearly disclaim that any investment advice is intended to be provided? The answer to this is not determinative, but it will factor into the position the DOL takes on whether this condition was met for purposes of the 5-part investment advice test.
  • Would a Retirement Investor reasonably believe the financial institution was offering fiduciary investment advice based on the financial institution’s marketing and other publicly available materials? Does the financial institution hold itself out as a “trusted adviser”?

The DOL also confirmed that the advice need only be a primary basis, not the primary basis.

Condition #5: “the advice will be individualized to the plan”

The DOL did not elucidate on this requirement in the new rule. A good rule of thumb, however, is that the more individually tailored the communication is to a specific recipient, the more likely the communication will be viewed as a recommendation by the DOL.

Financial institutions, especially those that believe they do not provide investment advice to retirement investors, should carefully consider whether the DOL’s expansive view of these requirements alters their status as a fiduciary so that they do not inadvertently cause a non-exempt prohibited transaction. An accompanying class exemption goes into effect on February 16, 2021 and would be available for those who become investment advice fiduciaries


It is crucial to note that the DOL’s 2016 conflicts of interest rule included an exception for incidental advice provided in connection with counterparty transactions with a plan fiduciary with financial expertise. As the DOL noted then, “[t]he premise… was that both sides of such transactions understand that they are acting at arm’s length, and neither party expects that recommendations will necessarily be based on the buyer’s best interests, or that the buyer will rely on them as such.” The new rule, however, contains no such exception.

In the DOL’s eyes, a financial institution that recommends a rollover to a retirement investor can generally expect to earn an ongoing advisory fee or transaction-based compensation from the IRA, whereas it may or may not earn compensation if the assets remain in the ERISA plan.

As noted above, the DOL will only treat the marketing of oneself as a “recommendation” if such communication is accompanied by a specific recommendation of a product or service. It is unclear whether the DOL will look for a recommendation of a product or service in fact or in effect, a thorny issue similarly raised under the predecessor 2016 rulemaking.

Comprehensive Analysis and Application of the SEC’s New Marketing Rule

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I. Comprehensive Application of the SEC’s New Marketing Rule

On December 22, 2020, the U.S. Securities and Exchange Commission (the “SEC” or “Commission”) adopted significant amendments to the advertising and solicitation rules applicable to registered investment advisers under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), as well as amendments to related rules governing recordkeeping and Form ADV (collectively, the “Amendments”).  Specifically, the SEC simultaneously amended Rule 206(4)-1 (the current “Advertising Rule”) and rescinded Rule 206(4)-3 (the current “Cash Solicitation Rule” and, together with the Advertising Rule, the “Existing Rules”) to create a new combined marketing Rule 206(4)-1 (the “Marketing Rule” or the “Rule”), which will comprehensively govern both advertising activities of advisers, as well as how they enter into solicitation/referral arrangements. The SEC also amended Rule 204-2 (the “Books and Records Rule”) under the Advisers Act to account for new recordkeeping obligations relating to the Rule and amended Form ADV to request additional information from advisers regarding their marketing activities.

The Amendments will become effective 60 days after publication in the Federal Register, and the Commission has adopted a compliance date 18 months from the effective date. As of the date of this publication, the Amendments have not yet been published in the Federal Register. After publication, early compliance is permissible, but advisers who choose to comply with the Rule prior to the compliance date must comply with all aspects of the Amendments.  The Rule does not apply to the marketing activities of registered investment companies or business development companies, as their marketing activities are covered under other rules. However, it does extend to marketing communications to private fund investors. Read the full White Paper here.

A Framework for the DOL’s New Proxy Voting Rule

The U.S. Department of Labor (DOL) has finalized a rulemaking that pertains to proxy voting and the exercise of other shareholder rights with respect to employee benefit plans subject to the U.S. Employee Retirement Income Security Act of 1974, as amended (ERISA).1 The rule applies to plans directly, as well as to commingled investment funds that hold “plan assets.”2 Plan sponsors, investment advisers registered with the U.S. Securities and Exchange Commission (SEC), and other service providers that either exercise shareholder rights on behalf of plans or who appoint those who do should pay particular attention to this final rule.3

As with the DOL’s recent Financial Factors rulemaking, this rule’s genesis was probably the DOL’s concern over the striking growth of environmental, social & governance (ESG) investing. Engagement with a company’s board, for example, is a popular method used by managers to address ESG concerns. But both rules apply much more broadly, including to those managers and mandates that do not take ESG factors into account. Neither this rule nor the Financial Factors rule, is limited to ESG.

The exercise of shareholder rights, including proxy voting, has long been considered fiduciary conduct under ERISA. This rule retains that characterization and defines the scope of responsibilities. In doing so, the rule supersedes DOL Interpretive Bulletin 2016-01 and the relevant portions in DOL Field Assistance Bulletin 2018-01.

As discussed more fully below, fiduciaries of plans and plan asset vehicles will need to review their proxy voting policies and practices regarding their use of proxy advisors, especially when those advisors offer voting recommendations or their platforms pre-populate votes.4 With this rule, proxy advisory firms continue to face increased scrutiny from U.S. regulators, notably the SEC and DOL, over their practices and influence.

From a substantive standpoint, the rule compels fiduciaries to only exercise shareholder rights, including proxy voting, if they are undertaken solely in accordance with the economic interests of the plan and its participants and beneficiaries. This entails the fiduciary discerning some economic benefit to the plan, beyond the plan merely being a shareholder, resulting from the exercise of shareholder activities by the plan alone or together with other shareholders.5 Fiduciaries may consider the longer-term consequences and potential economic impacts from the exercise of such rights, even if they are not currently readily quantifiable, which should strengthen (or at least not hinder) proxy voting and engagement related to material ESG issues.6 Importantly, a discernible economic benefit to the plan must be initially identified to pass muster under the rule, even if the shareholder activity does not result in a direct or indirect cost to the plan.

In the DOL’s view, for example, a fiduciary may have to vote against a shareholder proposal that would result in the issuer incurring direct or indirect costs if such proposal did not also describe “a demonstrable expected economic return” to the issuer. On the other hand, “the costs incurred by a corporation to delay a shareholder meeting due to lack of a quorum is an example of a factor that can be appropriately considered as affecting the economic interest of the plan.”

The costs of proxy voting and other shareholder rights must also be considered, as they too affect the economic interest of the plan. These costs may include direct costs to the plan, such as expenditures for analyzing portfolio companies and the matters to be voted on, determining how the votes should be cast, and ultimately submitting proxy votes to be counted. Moreover, the DOL notes that “[i]f a plan can reduce the management or advisory fees it pays by reducing the number of proxies it votes on matters that have no economic consequence for the plan that also is a relevant cost consideration.”7 Indirect costs are also relevant. For example, the fiduciary should consider the opportunity costs of the exercise of shareholder rights, such as opportunity costs for the client resulting from restricting the use of securities for lending to preserve the right to vote.8

The rest of the rule is more process-oriented, which speaks to how fiduciaries can satisfy these substantive obligations in practice.

First, fiduciaries need to evaluate material facts that form the basis for any particular proxy vote or other exercise of shareholder rights. Here, fiduciaries should consider material information that is known by, available to, or reasonably should be known by the fiduciary. In this respect, the DOL pointed to the fact that, under recent SEC guidance, clients of proxy advisory firms may become aware of additional information from an issuer that is the subject of a voting recommendation, and that an ERISA fiduciary would be expected to consider the relevance of such additional information if material.

Second, fiduciaries must maintain records on proxy voting activities and other exercises of shareholder rights. For fiduciaries that are SEC-registered investment advisers, the DOL intends that these recordkeeping obligations would be applied in a manner that aligns to similar proxy voting recordkeeping obligations under the U.S. Investment Advisers Act of 1940, as amended (Advisers Act).

Third, and as applicable, fiduciaries must exercise prudence and diligence in the selection and monitoring of (i) investment managers charged with proxy voting and (ii) proxy advisory firms selected to advise or otherwise assist with exercises of shareholder rights, such as providing research and analysis, recommendations regarding proxy votes, administrative services with voting proxies, and recordkeeping and reporting services. The fiduciary should consider the qualifications of the service provider, the quality of services being offered, and the reasonableness of fees charged in light of the services provided. ERISA fiduciaries should also ensure that, when considering proxy recommendations, they are fully informed of the potential conflicts of interest of proxy advisory firms and the steps such firms have taken to address them (e.g., reviewing proxy advisor conflict of interest disclosures, etc.). Finally, fiduciaries should review the proxy voting policies and/or proxy voting guidelines and the implementing activities of the service provider; this requirement, however, does not require use of custom policies.

Fiduciaries may adopt proxy voting policies pursuant to a safe harbor and, if so, review them periodically for compliance with the rule (e.g., every two years). These policies may not preclude (i) submitting a proxy vote when the fiduciary prudently determines that the matter being voted upon is expected to have a material effect on the value of the investment or the investment performance of the plan’s portfolio (or investment performance of assets under management in the case of an investment manager) after taking into account the costs involved, or, conversely, (ii) refraining from voting when the fiduciary prudently determines that the matter being voted upon is not expected to have such a material effect after taking into account the costs involved. The rule specifically provides two safe harbors, either or both of which may be utilized when deciding whether to vote. The safe harbors are not the exclusive means to satisfy the rule or represent minimum requirements.

  1. Safe Harbor #1: A policy to limit voting resources to particular types of proposals that the fiduciary has prudently determined are substantially related to the issuer’s business activities or are expected to have a material effect on the value of the investment. The reference to the value of the investment rather than the plan’s total investment is intended to make clear that the evaluation could be at the investment manager level dealing with a pool of investor’s assets or at the aggregate plan level. The DOL expects that proposals relating to corporate events (e.g., mergers and acquisitions, dissolutions, conversions, or consolidations), buybacks, issuances of additional securities with dilutive effects on shareholders, or contested elections for directors, are the types of votes that would materially affect the investment.
  2. Safe Harbor #2: A policy of refraining from voting on proposals or particular types of proposals when the plan’s holding in a single issuer relative to the plan’s total investment assets is below a quantitative threshold that the fiduciary prudently determines, considering its percentage ownership of the issuer 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 plan’s portfolio (or investment performance of assets under management in the case of an investment manager).

In response to concerns raised by some commenters, the safe harbors in the final rule are intended to be flexible enough to clearly enable fiduciaries to vote to establish a quorum of mutual fund shareholders or on other fund matters. On this point, the DOL noted that fiduciaries may also adopt voting policies that consider the detrimental effect on the plan’s investment due to the costs (direct and indirect) incurred related to delaying a shareholders’ meeting. The rule envisions fiduciaries having considerable flexibility in fashioning proxy voting policies and the opportunity to deviate from the policies in certain instances.

Proxy advisors remain top-of-mind for the DOL. The safe harbors are intended to provide fiduciaries the ability to operationalize the rule without having to seek recommendations on a vote-by-vote basis from proxy advisors. The rule prohibits fiduciaries from adopting a practice of following the recommendations of a proxy advisory firm without first determining that such firm or service provider’s proxy voting guidelines are consistent with the fiduciary’s obligations under the rule.9 As with the SEC, the DOL expects fiduciaries, under certain circumstances, to conduct a more particularized voting analysis than what may be conducted under the general guidelines. The DOL acknowledged that some plans rely on proxy advisory firms’ pre-population and automatic submission mechanisms for proxy votes but noted that adopting such a practice for all proxy votes effectively outsources their fiduciary decision-making authority.

The rule continues to recognize and account for the fact that an investment manager of a plan asset pooled investment vehicle may be subject to an investment policy statement that conflicts with the policy of another plan investor. In this case, compliance with ERISA requires the investment manager to reconcile, to the extent possible, the conflicting policies (assuming compliance with each policy would otherwise be consistent with ERISA). In the case of proxy voting, the investment manager generally must vote (or abstain from voting) the relevant proxies to reflect such policies in proportion to each plan’s economic interest in the investment vehicle. Investment managers of pooled funds, however, typically develop an investment policy statement and require participating plans to accept the investment manager’s proxy voting policy as a condition to subscribe, which remains permitted under the rule. The investment manager’s policies would need to comply with this rule, and the fiduciary responsible for the plan’s subscription in the fund would be obligated to assess whether the investment manager’s policies are consistent with this rule before subscribing in the fund.10

As noted above, the rule does not directly apply to investment vehicles that do not hold plan assets, such as mutual funds. The rule, for example, does not require ERISA fiduciaries to scrutinize a mutual fund’s voting practices in which the plan has an investment. The DOL does, however, contemplate that ERISA fiduciaries will consider the mutual fund’s voting policies as part of its overall consideration of the mutual fund as a prudent investment in accordance with the Financial Factors rule. Thus, fiduciaries should consider whether the investment fund’s voting policies are expected to have a material effect on the risk and/or return of an investment.

The rule’s compliance date is Jan. 15, 2021, subject to the following:

  • All fiduciaries should begin to review their proxy voting policies and practices in light of the new rule, especially plan investment committees and investment managers of separate accounts.
  • Fiduciaries that are investment advisers registered with the SEC must comply by Jan.15, 2021, with respect to the requirements to (i) evaluate material facts that form the basis for any particular proxy vote or other exercise of shareholder right and (ii) maintain records on proxy voting activities and other exercises of shareholder rights. The DOL intends that these requirements align with existing obligations under the Advisers Act, including Rules 204-2 and 206(4)-6 thereunder and the 2019 SEC Guidance and 2020 SEC Supplemental Guidance. Other types of fiduciaries have until Jan. 31, 2022, to comply with these requirements.
  • All fiduciaries shall have until Jan. 31, 2022, to comply with the requirements that they not adopt a practice of following the recommendations of a proxy advisory firm or other service provider without a determination that such firm or service provider’s proxy voting guidelines are consistent with the rule. Fiduciaries of pooled investment vehicles also have until that date to confirm the fund’s proxy voting policies with the rule.

1 The rule does not apply to the exercise of shareholder rights on behalf of non-ERISA plans, such as IRAs and governmental plans.

2 Investment companies registered under the U.S. Investment Company Act of 1940, as amended, do not hold plan assets and thus not subject to ERISA or this rule. Hedge funds and other commingled vehicles that fail to satisfy one of the exceptions set forth in the DOL’s plan assets regulation, on the other hand, are subject to ERISA and this rule. Similarly, bank-maintained collective investment trusts are subject to ERISA and this rule.

3 The rule does not apply to proxy voting that is passed through to participants and beneficiaries with accounts holding such securities in an individual account plan.

4 Firms that agree to act as “investment managers,” within the meaning of Section 3(38) of ERISA, should ensure the investment management agreement is clear on who has the responsibility to exercise shareholder rights on behalf of the plan. When the authority to manage plan assets has been delegated to an investment manager, the investment manager has exclusive authority to vote proxies or exercise other shareholder rights, except to the extent the plan, trust document, or investment management agreement expressly provides that the responsible named fiduciary has reserved to itself (or to another named fiduciary so authorized by the plan document) the right to direct a plan trustee regarding the exercise or management of some or all of such shareholder rights.

5 The proposed rule included a requirement that the fiduciary consider only factors that they prudently determine will affect the economic value of the plan’s investment based on a determination of risk and return over an appropriate investment horizon consistent with the plan’s investment objectives and the funding policy of the plan. The DOL eliminated this condition because of its potential compliance costs and that it may not be apparent that a particular vote will affect the plan’s investment return. A similar revision was made to the final Financial Factors rulemaking; thus, even the DOL admits fiduciaries need not be clairvoyant in evaluating how an investment decision, or the exercise of shareholder rights, on some basis (ESG or not) will materially affect the plan’s return in the future. Instead, fiduciaries should follow a thoughtful, prudent process in reaching the position that an investment, or the exercise of rights appurtenant to such investment, is in the economic interests of the plan.

6 As with the Financial Factors rulemaking, the DOL cautioned fiduciaries against taking too elastic an interpretation of economic benefits that could flow to the plan, by noting that “vague or speculative notions that proxy voting may promote a theoretical benefit to the global economy that might redound, outside the plan, to the benefit of plan participants would not be considered an economic interest under the final rule.”

7 The DOL also noted that it would “not be appropriate for plan fiduciaries, including appointed investment managers, to incur expenses to engage in direct negotiations with the board or management of publicly held companies with respect to which the plan is just one of many investors.” It is questionable whether this assertion is supported by the rule itself.

8 The DOL acknowledged that multiple investment managers may be responsible for managing a plan’s assets, and accordingly revised the rule to permit each investment manager to apply the rule to its specific mandate. The DOL noted, however, that “where the plan’s overall aggregate exposure to a single issuer is known, the relative size of an investment within a plan’s overall portfolio and the plan’s percentage ownership of the issuer, may still be relevant considerations in appropriate cases in deciding whether to vote or exercise other shareholder rights.”

9 The fiduciary selecting and using a proxy advisor, therefore, must review the proxy advisor’s voting guidelines against this rule in addition to separately determining whether a specific recommendation necessitates a particularized analysis. The review of the proxy advisor proxy voting guidelines should be addressed at the outset of the relationship with the proxy advisor and when the proxy advisor updates its guidelines (e.g., annually).

10 Uniform policies utilized by the investment manager across client accounts are still permissible under the rule, provided the policies comply with this rule.