Risk & Reward

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.

DOL Finalizes Investment Advice Rulemaking

The U.S. Department of Labor (DOL) released last week a new class exemption that would provide relief to registered investment advisers, broker-dealers, banks and insurance companies for the receipt of compensation as a result of providing investment advice, including rollover advice, to ERISA-covered plans and individual retirement accounts (IRAs). Also included in this rulemaking package is new guidance from the DOL on its recent reinstatement of the traditional five-part test when one becomes an investment advice fiduciary.

Here we provide a brief overview of this significant rulemaking.

Here are the key takeaways:

  • Under the DOL’s five-part test, for advice to constitute “investment advice,” a financial institution or investment professional must (1) render advice to the plan as to the value of securities or other property, or make 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 agreement, arrangement, or understanding with the plan, plan fiduciary, or IRA owner, that; (4) the advice will serve as a primary basis for investment decisions with respect to plan or IRA assets; and that (5) the advice will be individualized based on the particular needs of the plan or IRA. If a financial services firm becomes a fiduciary to a plan under this test, then the resulting compensation from that advice would trigger the prohibited transaction restrictions, necessitating an exemption. While there are currently existing exemptions that can be utilized, they cover discrete transactions, whereas the DOL’s new class exemption applies broadly, similar to how the DOL’s 2016 Best Interest Contract Exemption was designed to function (see below on status of that exemption).
  • The DOL indicates that advice to take a distribution of assets from a retirement plan is effectively advice to sell, withdraw, or transfer investment assets currently held in the plan, and, therefore, falls within the definition of fiduciary advice, assuming all five parts of the test are satisfied. DOL’s treatment of most rollover recommendations as investment advice is a departure from its historical position, but pairs well with its 2016 rulemaking and the Securities and Exchange Commission’s Regulation Best Interest. Note, however, that the DOL will not pursue claims for breach of fiduciary duty or prohibited transactions based on rollover recommendations made before the effective date of the new final exemption if the recommendations would not have been considered fiduciary communications under the reasoning of the DOL’s historical guidance (i.e., the Deseret Letter).
  • The new exemption requires the investment advice to meet the Impartial Conduct Standards, namely: a best interest standard; a reasonable compensation standard; and a requirement to make no materially misleading statements about recommended investment transactions and other relevant matters. The exemption includes disclosure requirements, conflict mitigation, and a compliance review. Prior to engaging in a rollover recommended, financial institutions must provide documentation of the specific reasons for the rollover recommendation to the retirement investor, including the reasons it satisfies the best interest standard. This exemption is partly based upon the temporary enforcement policy announced in Field Assistance Bulletin (FAB) 2018-02.
  • A financial institution’s reliance on the new exemption also requires it to establish, maintain and enforce policies and procedures designed to ensure that they comply with the Impartial Conduct Standards.
  • The exemption now includes a self-correction mechanism so that certain technical violations of the exemption’s conditions do not cause the total loss of exemptive relief.
  • The exemption does not cover advice arrangements that rely solely on robo-advice; however, the exemption would cover hybrid robo-advice, namely, advice generated by computer models coupled with interaction with an investment professional.
  • The DOL’s new rulemaking package removes 2016’s Best Interest Contract Exemption and the Class Exemption for Principal Transactions in Certain Assets Between Investment Advice Fiduciaries and Employee Benefit Plans and IRAs. Moreover, pre-existing prohibited transaction class exemptions that had been amended as part of the 2016 rulemaking (e.g., 75-1, 77-4, 80-83, 83-1, 84-24 and 86-128) have been reinstated and published on the DOL’s website in their original form.
  • The new exemption will be effective and available to financial institutions beginning 60 days after the date of publication in the Federal Register; however, FAB 2018-02 remains in place for a year to smooth the transition.

Please be on the lookout for our full analysis of this important development after the holidays.

Key Considerations: DOL’s New Final Regulation on ERISA’s Investment Duties (ESG-Related or Not)

The U.S. Department of Labor (DOL) finalized amendments to the investment duties of a fiduciary subject to the U.S. Employee Retirement Income Security Act of 1974, as amended (ERISA).1 The rule amendments were aimed at ERISA fiduciaries that utilize products and strategies that incorporate environmental, social and/or governance (ESG) factors. Though the DOL opted not to let the final rule get bogged down in the ESG-lexicon quagmire by removing all express references to ‘ESG,’ the final rule clearly and directly applies to fiduciaries that consider ESG factors when investing on behalf of ERISA plans and funds that hold “plan assets.” Indeed, all ERISA fiduciaries that make investment decisions (including the selection of investment funds for participant-directed plan lineups), regardless of whether ESG is even implicated, should review this rule carefully.

The rule becomes effective 60 days after publication in the Federal Register. Plans have until April 30, 2022 to make any changes to their “qualified default investment alternatives” (QDIAs), within the meaning of 29 C.F.R. § 2250.404c-5, as a result of this rule. The rule contemplates a grandfathering mechanism, which will be highly fact-specific.2 The DOL further noted that it “will not pursue enforcement, and does not believe any private action would be viable, pertaining to any action taken or decision made with respect to an investment or investment course of action by a plan fiduciary prior to the effective date of the final rule to the extent that any such enforcement action would necessarily rely on citation to this final rule.”

The final rule builds upon the original investment duties regulation, which provided a safe harbor for fiduciaries in satisfying their duty of prudence under ERISA. The final rule, like the original, compels fiduciaries to give appropriate consideration to numerous factors regarding the composition of the plan portfolio as it relates to diversification, liquidity and current return of the portfolio relative to the anticipated cash flow needs of the plan, and the projected return of the portfolio relative to the funding objectives of the plan. Importantly for 3(38) investment managers, the final rule preserves the aspects of the original regulation that allowed investment managers to rely and act on information provided by the appointing fiduciary in fulfilling these duties with respect to the plan portfolio over which it has discretion.

The final rule withdraws DOL Interpretive Bulletin 2015-01 and supersedes “ESG Investment Considerations” in DOL Field Assistance Bulletin 2018-01.

This final rule does not address an ERISA fiduciary’s responsibilities with respect to proxy voting and the exercise of other shareholder rights. The DOL recently proposed a rule on this topic, though it has yet to move forward with the proposal. Until a final rule emerges, fiduciaries should continue to follow DOL Interpretive Bulletin 2016-01 and DOL Field Assistance Bulletin 2018-01.

Key Considerations

The final rule preserves the essence of the original investment duties regulation (and ERISA) by allowing ERISA fiduciaries considerable leeway in crafting investment portfolios. The DOL thus admitted that, as a general matter, there is total parity between investment strategies and products, whether ESG-related or not. In other words, an ERISA fiduciary may manage plan assets while taking into account ESG risks and opportunities without violating the rule.

The final rule presents five distinct issues worth considering (1) pecuniary factors; (2) comparing investment alternatives; (3) duty of loyalty; (4) special circumstances/non-pecuniary factors/tie-breakers, and (5) QDIAs.

Pecuniary Factors

Whether investing on behalf of an ERISA-covered defined benefit plan or selecting plan investment options for a participant-directed plan, the final rule compels fiduciaries to consider pecuniary factors only, absent special circumstances (discussed below), when evaluating the risk and return profiles of investments. The rule defines a “pecuniary factor” as one “that a fiduciary prudently determines is expected to have a material effect on the risk and/or return of an investment based on appropriate investment horizons consistent with the plan’s investment objectives and the funding policy….”3 The DOL expressly recognized that ESG factors may be pecuniary factors under the rule.4 The requirement that only pecuniary factors be considered is a legal requirement, not a safe harbor.

The final rule’s definition of pecuniary factors is forward-looking in nature, meaning a fiduciary need not know that a factor will materially affect risk/return at the time of the investment. Instead, the fiduciary must be prudent in coming to that conclusion based on the facts and circumstances. This change by the DOL should give comfort to fiduciaries who are closely tracking the emerging data of various ESG (and other) factors’ impact on investment performance. Fiduciaries should take note that the DOL has repeatedly cautioned fiduciaries against disproportionately weighting the materiality of a factor based on existing data.

The DOL opted to avoid defining the slippery concept of materiality. The DOL said in the preamble to the final rule that it “believes that fiduciaries and investment managers are generally familiar with that concept from its use in connection with both ERISA and the federal securities laws.” This seemingly allows the concept of pecuniary factors to evolve with market consensus on materiality and ultimately on how other regulators define materiality for these purposes. Yet, the DOL acknowledged that the following may be material, and thus, pecuniary factors under the rule: (1) an investment manager’s brand/reputation; (2) proprietary products; and (3) a fund or product’s legal regime that confers greater investor protection and/or improved disclosures.

As with any other evaluation of prospective investments, a fiduciary should first determine that it has sufficient skills and expertise to determine that the ESG (or any other) factor presents economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories (if not, the determination should be made by another fiduciary that has such expertise and skill).5 Moreover, the DOL apparently will look for risk controls in place commensurate with the complexity, nature and size of the investment activity (the implication is that fiduciaries that consider ESG factors should have rigorous controls in place to ensure that they are properly determining factors to be  pecuniary factors under the rule).

In the context of ERISA-covered participant-directed plans, the decision as to which funds populate the plan lineup is subject to ERISA’s fiduciary duties and this new rule, among others. In the preamble to the final rule, the DOL addressed whether a fiduciary could select an ESG investment fund, product or model portfolio based solely on participant request or because of the potential for increased contributions to the plan. In short, these types of considerations are not pecuniary factors and, therefore, the responsible fiduciary may not base its decision to include an ESG fund, product or model portfolio as a designated investment alternative without separately determining that the pecuniary reasons for such inclusion satisfy the rule. As discussed below, however, participant requests and the like may be “tie-breakers” in selecting between alternative investment options.

Comparing Investment Alternatives

Under the final rule, the fiduciary must compare investments or investment courses of action (e.g., selection of designated investment alternative for participant-directed plans) based on factors “that are expected to result in a material difference among reasonably available alternatives with respect to risk and/or return.” This comparison requirement is, therefore, not limitless. Thus, a fiduciary does not need to consider all factors that differentiate investment funds, only ones that are pecuniary. Moreover, fiduciaries are under no obligation to scour the market for the lowest cost investment opportunities, much less select the cheapest available investments.

The DOL further confirmed that the fiduciary need not expend considerable resources on searching for investment opportunities or considering an infinite number of investment alternatives. Instead, the fiduciary’s duty to evaluate alternative investment opportunities is limited to comparing alternatives that are reasonably available under the circumstances. This means that the rule “allow[s] for the possibility that the characteristics and purposes served by a given investment…may be sufficiently rare that a fiduciary could prudently determine, and document, that there were no other reasonably available alternatives for purposes of this comparison requirement.”

Duty of Loyalty

Fiduciaries are already well aware that ERISA imposes a duty of loyalty, in addition to the prudence requirements discussed above. The final rule incorporates this specific fiduciary duty by prohibiting fiduciaries from subordinating the interests of plan participants and beneficiaries in their retirement income to non-pecuniary goals. Though this may seem to be an example of form over function, the DOL opted not to include the duty of loyalty under the rule’s general safe harbor characterization, meaning fiduciaries will likely not only be conservative in satisfying the rule’s requirements but may also opt for even stronger controls/analysis/documentation than the rule technically requires to ensure they do not run afoul of the loyalty concerns the DOL has expressed in the context of ESG.

Special Circumstances/Non-Pecuniary Factors/Tie-Breakers

Prior DOL guidance provided that if, after an evaluation, alternative investments appear economically indistinguishable, a fiduciary may then, in effect, “break the tie” by relying on a non-pecuniary factor. Commenters argued that the proposal effectively required equivalence between investments. The DOL suggested that they did not mean for investment alternatives to have identical characteristics, just equivalent roles in the plan’s investment portfolio. Commenters argued that indistinguishability in liquid markets is all but impossible and are, in turn, never perfectly correlated.

Under the final rule, if a fiduciary is unable to determine which investment is in the best interests of the plan on the basis of pecuniary factors alone, the fiduciary may base the investment decision on non-pecuniary factors, provided the fiduciary documents the following: (1) why pecuniary factors were not sufficient to select the investment; (2) how the investment compares to the alternative investments; and (3) how the chosen non-pecuniary factors are consistent with the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan. This effectively prohibits ERISA fiduciaries from choosing investments with expected reduced returns or enhanced risks in order to secure non-pecuniary benefits.

The third condition is a hemmed-in version of the historical tie-breaker test. Simply, the DOL split the difference from the proposal, which all but eliminated the tie-breaker mechanism, and instead has allowed a tie-breaker but only on the basis of a pecuniary-light factor. Under the final rule, a fiduciary no longer appears able to select an investment fund based on the ethos of the plan sponsor (assuming the other conditions of the rule are met). Instead, the non-pecuniary factor must at least have some nexus to participants’ and beneficiaries’ retirement income or financial benefits. The DOL indicated that responding to participant demand in order to increase retirement plan savings may be consistent with the interests of the participants and interests in their retirement income or financial benefits under the plan. In contrast, selecting an investment option that “would bring greater personal accolades to the chief executive officer of the sponsoring employer, or solely on the basis of a fiduciary’s personal policy preferences, would not.”

The same standards apply to selecting investment funds, products and model portfolios for a participant-directed plan lineup. The DOL admonished fiduciaries to “carefully review the prospectus or other investment disclosures for statements regarding ESG investment policies and investment approaches.” In particular, the DOL stressed that fiduciaries should be “cautious in exercising their diligence obligations under ERISA when disclosures, whether in prospectuses or marketing materials, contain references to non-pecuniary factors or collateral benefits in a fund’s investment objectives or goals or its principal investment strategies.”

The DOL envisions that fiduciaries will evaluate fund prospectuses and other disclosures to determine if the fund uses an ESG or sustainability rating system of index. If the fund uses such a rating system or index, the fiduciary, as part of its due diligence, would need to consider whether the rating system or index “evaluates one or more factors that are not financially material to investments.” If so, the selection of the fund is a special circumstance, thereby requiring the fiduciary to satisfy the aforementioned heightened requirements.

On this point, the DOL indicated that a fiduciary would have to understand how the ratings are actually determined, such as the rating’s methodology, weighting, data sources, performance benchmarks and the underlying assumptions utilized. Moreover, “a fiduciary may not assume that combining [multiple factors] into a single rating, index or score creates an amalgamated factor that is itself pecuniary.”

QDIAs

On QDIAs, DOL stressed that the proposal was never intended to block investment funds, products or model portfolios that treat ESG factors as pecuniary in nature from being QDIAs. The final rule better captures this intent by only prohibiting those QDIAs whose investment objectives, goals or principal investment strategies include, consider or indicate, one or more non-pecuniary factors. Crucially, the tie-breaker mechanism is not available when selecting QDIAs. This means that a fund will no longer qualify as a QDIA if its investment objectives, goals or principal strategies include a non-pecuniary factor, even if including such fund as a QDIA is in response to participants’ request or otherwise increase the desirability of the plan to participants.

The DOL claimed fiduciaries can apply the rule to QDIAs easily and objectively. They indicated, for example, that a plan fiduciary can simply look at the investment fund’s prospectus to determine whether the fund is qualified or disqualified as a QDIA under the final rule. The DOL specifically pointed to Form N-1A to ascertain whether non-pecuniary considerations form a material part of a fund’s investment objectives or principal strategies. The DOL is under the impression that disclosures for other types of investment vehicles, such as collective investment trusts and insurance separate accounts, would provide sufficient information for these purposes.

As noted above, the DOL envisions fiduciaries evaluating fund prospectuses and other disclosures to determine if the fund uses an ESG or sustainability rating system of index. Again, if the fund uses such a rating system or index, the fiduciary, as part of its due diligence, would need to consider whether the rating system or index “evaluates one or more factors that are not financially material to investments.” If so, the fund would no longer qualify as a QDIA under the final rule.

Funds that use positive or negative screening may similarly result in their disqualification as a QDIA, if the screening involves non-pecuniary factors that effectively results in the exclusion of certain sectors or categories of investments, and such exclusions are reflected in the fund’s investment objectives or principal strategies. If these exclusions are not reflected in the investment alternative’s objectives or principal strategies, but they are otherwise disclosed, the fiduciary evaluating such fund is expected to undertake “an economic analysis of the economic consequences to the plan of such an exclusion and determining that such an exclusionary policy would not be economically harmful to the plan.”

The regulation does not apply to investment alternatives that are not designated investment alternatives under the plan (e.g., brokerage windows). However, DOL noted that the rule should not be construed as addressing the application of ERISA’s duties of prudence and loyalty to brokerage windows or other non-designated investment alternatives that grant participants and beneficiaries access to investments that are not designated investment alternatives, and suggests there may be future rulemaking to address this.

Other Considerations

The DOL responded to concerns that the regulation may redirect or stall the development of ESG practices, particularly as the U.S. Securities and Exchange Commission (SEC) continues to monitor ESG developments. Commenters pointed to the SEC’s recent solicited public comment request on the “Names Rule” under the U.S. Investment Company Act of 1940, as amended. The DOL noted in the preamble to the final rule that it did not think it needed to delay a final rule until the SEC decides to take action on the Names Rule. The DOL also recognized that some financial regulators are looking at whether ESG risk presents systemic risk to the financial markets. The DOL responded, “if financial regulators adopt new rules or policies that affect financial market participants, that may create pecuniary or non-pecuniary considerations for plan fiduciaries apart from ERISA.” It isn’t entirely clear what the DOL meant by this. One interpretation is that other regulators’ interpretation of materiality can inform an ERISA fiduciary’s determination as to whether a particular factor is pecuniary or not under the final rule. Yet a contrary interpretation is that the DOL, by using the language “apart from ERISA,” intends to largely wall off the final rule from other regulators’ potentially increasing liberalization over what factors are material to investment return and risk.

The DOL likewise responded to commenters who raised concerns that this rulemaking would interfere with how other federal agencies were addressing ESG risks. For example, the DOL acknowledged that the State Department, Treasury Department, Commerce Department and Department of Homeland Security have taken positions on supply chain links to entities that engage in human rights abuses, including, for example, forced labor in China. Even though supply chain risk is an ESG factor, the DOL took the position that it sees no fundamental conflict between this final rule and positions regarding supply chain risk raised by other government agencies.

Somewhat relatedly, the DOL responded to a comment that the rule would conflict with the position it took regarding the federal Thrift Savings Plan (TSP), namely, to prohibit the plan from investing in Chinese equities. While noting that the TSP is not covered by Title I of ERISA, the DOL added that its “position with respect to investments in China was informed by consideration of specific matters relating to investment risk, including inadequate investor disclosures and legal protections, that are consistent with “pecuniary factors” as used in the final rule.” The DOL further added that “other concerns were raised because the Federal Government matches TSP contributions and investments in China might result in the Federal Government funding activities that are opposed to U.S. national security interest.” Its first explanation, namely that it found disclosures related to Chinese holdings insufficient and legal protections were insufficient, is noteworthy for all ERISA fiduciaries because the final rule states that sufficiency of disclosures and legal protections are pecuniary factors. Thus, a fiduciary may wish to exercise caution in how it evaluates and documents the pecuniary factors in deciding on an investment that has Chinese holdings in light of the DOL’s concern.

The DOL dismissed concerns that the final rule would conflict with international ESG rules and trends by dismissing the sheer relevance of such trends and non-U.S. rules. Specifically, the DOL stated, “international trends in the consideration of ESG factors or other actions of regulators in other countries are not an appropriate gauge for evaluating ERISA’s requirements as they apply to investments of ERISA-covered employee benefit plans.”

The final rule is not immune to rescission or change by Congress or the DOL under a future administration.


1 29 C.F.R. § 2550.404a-1.

2 In a footnote to the preamble of the final rule, the DOL stated, “[t]he Department notes that it may be that a fiduciary could prudently determine that the expected return balanced against the costs and risks of loss associated with divesting an investment made before the effective date of the rule are such that continuing to hold that investment would be appropriate even if the fiduciary as part of its monitoring process determined that the investment, or aspects of the decision-making process, does not comply with the final rule.”

3 The proposal’s language seemingly required that, before an ERISA fiduciary could treat an ESG or other factor as a pecuniary factor, the ESG or other factor would already have had to be determined by other investment professionals as being material to investment performance.

4 In the preamble to the final rule, the DOL noted, for example, that “a company’s improper disposal of hazardous waste would likely implicate business risks and opportunities, litigation exposure, and regulatory obligations” and that “[d]ysfunctional corporate governance can likewise present pecuniary risk that a qualified investment professional would appropriately consider on a fact-specific basis.”

5 The DOL indicated that it does not intend the term “generally accepted investment theories” to freeze the evolution of investment theory or practice, but rather “to establish a regulatory guardrail against situations in which plan investment fiduciaries might be inclined to use…policy-based metrics in their assessment of the pecuniary value of an investment or investment plan that are inherently biased toward inappropriate overestimations of the pecuniary value of policy-infused investment criteria.”

New DOL Rule Proposal Risks Chilling Proxy Voting and Shareholder Engagement

The U.S. Department of Labor (DOL) released its long-awaited proxy voting rule proposal on Aug. 31. If adopted without modification, fiduciaries of plans (e.g., investment managers) subject to the U.S. Employee Retirement Income Security Act of 1974, as amended (ERISA), may shy away from voting proxies and participating in shareholder engagement on matters that do not demonstrably improve the value of the plan’s holding in the short-term. Thus, the exercise of shareholder rights on environmental, social and governance (ESG) issues, the benefits of which may be long-term in nature, may indeed be squeezed out of proxy voting policies of ERISA plan fiduciaries. Here are the key takeaways:

  • The DOL’s longstanding position is that the fiduciary act of managing plan assets includes decisions on the voting of proxies and other exercises of shareholder rights. Over the past few decades, the DOL has issued guidance on a fiduciary’s responsibilities regarding proxy voting and shareholder engagement. The DOL’s most recent guidance is Interpretive Bulletin (IB) 2016-01, as modified by Field Assistance Bulletin 2018-01. The guidance generally permitted fiduciaries to engage in these activities when the responsible fiduciary concluded that there is a reasonable expectation (by the plan alone or together with other shareholders) that such activity is likely to enhance the value of the plan’s investment in the issuer, after taking into account the costs involved.
  • The DOL has also long held that, while ERISA does not permit fiduciaries to subordinate the economic interests of participants and beneficiaries to unrelated objectives in voting proxies or in exercising other shareholder rights, a “reasonable expectation” that the plan is likely to enhance the value of the plan’s investment may be demonstrated where, as is typically the case, the plan’s investment is long-term in nature, or where a plan may not be able to easily divest of the particular holding. The DOL noted in IB 2016-01, for example, that the benefits of shareholder engagement may be difficult to quantify in the short-term but nevertheless can be realized in the long-term.
  • As with its ESG guidance, the DOL’s stance on proxy voting and other forms of shareholder rights have been a political football. Starting with the Clinton Administration in the mid-90s, each administration has taken slightly different approaches. Ultimately, the administrations have gone back and forth as to whether a weighing of the costs and benefits associated with proxy voting is necessary for each such vote or whether such an analysis is reserved for unusually expensive votes or engagements. In 2016, the DOL pointed out that proxy voting rarely entails a significant expenditure of plan assets, and because the value of the vote/engagement may be long-term in nature, there was rarely an issue where the costs outweighed the benefits. Moreover, because many plans’ investments track indices, it is often necessary to engage issuer boards rather than to divest the plan’s exposure in that company. And so, the DOL reasoned in IB 2016-01, the general rule was that proxy voting and shareholder engagement was permissible in most instances.
  • The new proposal provides that the responsible plan fiduciary must vote a proxy where the fiduciary prudently determined that the matter being voted upon would have an economic impact on the plan after taking costs into account. Conversely, the plan fiduciary must not vote any proxy unless the fiduciary determines that the matter being voted upon would have an economic impact on the plan after taking costs into account. This begs the following questions:
    • How much evidence must the fiduciary marshal to demonstrate that a particular vote would have an economic impact on the plan’s investment? While the proposal allows the fiduciary to determine the “appropriate investment horizon,” it raises the prospect that long-term benefits, which may not be readily quantifiable today, could be afforded less weight.
    • Does the benefit of engagement by a group of shareholders count? Prior DOL guidance recognized that benefits from the exercise of shareholder rights might arise from the plan by itself or in combination with other shareholders. Yet, the new proposal seems to ignore this prospect. The proposal instead focuses specifically on the plan’s holdings in the issuer relative to the plan’s portfolio (as well as the plan’s percentage ownership of the issuer) for purposes of calculating whether the plan will stand to economically benefit from the shareholder activity. Because the plan by itself is likely to have a relatively small ownership stake in any particular issuer, and the plan is required under ERISA to be well diversified, this language in the proposal could tilt a fiduciary away from voting.
    • What are the “costs”? The DOL has long understood that plans have rarely incurred the cost of proxy voting and shareholder engagement. Yet the DOL, in the preamble to the proposal, suggests that the costs may not be fully understood. Moreover, the proposal suggests that the costs the issuer incurs as a result of the voting and engagement are effectively costs to the plan (the idea being, apparently, that any cost to the company’s bottom line necessarily diminishes the value of the plan’s investment). Finally, the DOL suggests that opportunity costs are a relevant consideration, though it is unclear how a fiduciary could actually quantify this.
  • As noted above, successive administrations have largely fought over how often the ERISA fiduciary must undertake this cost-benefit analysis with respect to proxy voting and other shareholder rights. In 2008, the DOL envisioned the fiduciary undertaking the test rather routinely. Yet, the DOL changed its tune in 2016 to provide that the test would be a rare occurrence because, in most cases, the costs were negligible, and the benefits were assumed. Under the proposal, the DOL takes the position that the fiduciary must evaluate on a vote-by-vote basis whether the plan will receive some economic benefit as a result of the shareholder activity. The DOL, to its credit, recognized that a vote-by-vote analysis would be costly and onerous. Thus, the proposal introduces the concept of “permitted practices,” which, while not safe harbors, are examples of voting policies the DOL thinks the fiduciaries can efficiently rely upon to satisfy their compliance requirements under the proposal. The following are specific examples of such voting policies, though the DOL solicited feedback on whether other examples should be provided in a final rulemaking. The DOL stressed that these “permitted practices” are intended to be flexible and that fiduciaries are free to deviate from them if it’s prudent under the circumstances or otherwise tailor them to the plan (e.g., provide that the plan will vote in accordance with management’s recommendation for uncontested elections of directors, but devote resources when voting on buy-backs, dilutive issuances of securities, etc.). Ultimately, the policies must be “reasonably designed” to serve the plan’s economic interest.
    • Example A: A policy of voting proxies in accordance with the voting recommendations of management of the issuer on proposals that the fiduciary has prudently determined are unlikely to have a significant impact on the value of the plan’s investment, subject to any conditions determined by the fiduciary as requiring additional analysis because the matter being voted upon may present heightened management conflicts of interest or is likely to have a significant economic impact on the value of the plan’s investment.
    • Example B: A policy that voting resources will focus only on particular types of proposals that the fiduciary has prudently determined are substantially related to the corporation’s business activities or likely to have a significant impact on the value of the plan’s investment (e.g., mergers, dissolutions, buy-backs, etc.).
    • Example C: A policy of refraining from voting on 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 outcome of the vote is unlikely to have a material impact on the investment performance of the plan’s portfolio (or investment performance of assets under management in the case of an investment manager). The DOL floated 5 percent as a potential threshold but specifically requested comments on it. As before, the DOL indicated that such policies would not preclude a fiduciary from voting in any particular case in which a fiduciary subsequently determines that the vote would have an economic impact on the plan.
  • The proposal requires that the fiduciary’s proxy voting policies be reviewed at least once every two years. Moreover, the responsible fiduciary must maintain records on proxy voting activities and other shareholder rights, including records that demonstrate the basis for particular proxy votes and exercises of shareholder rights.
  • The proposal requires that the fiduciary investigate the material facts that form the basis for any particular proxy voting/exercise of shareholder rights. The fiduciary may not adopt a practice of simply following the recommendations of a proxy advisory firm or other service provider without appropriate supervision and a determination that the service provider’s proxy voting guidelines are consistent with the economic interests of the plan and its participants and beneficiaries. A plan fiduciary using a proxy advisory firm is, therefore, responsible for understanding the conflicts of interest that could affect the proxy advisory firm’s recommendations.
  • The proposal preserves key aspects of prior DOL guidance related to proxy voting, specifically:
    • The fiduciary must be prudent in the selection and monitoring of persons selected to advise or otherwise assist with exercises of shareholder rights, such as research and analysis, recommendations regarding proxy votes, administrative services with voting proxies, and recordkeeping and reporting services. Here, the DOL explains that, as part of the duty to monitor, fiduciaries should require documentation of the rationale for proxy voting decisions so that fiduciaries can periodically monitor proxy voting decisions made by third parties.
    • A plan fiduciary must also assess and monitor an investment manager’s use of any proxy advisory firms, including any reviews by the manager of the advisory firm’s policies and procedures for identifying and addressing conflicts of interest.
    • Proxy voting decisions may be delegated to third-party investment managers.
    • Investment managers of pooled investment funds may require that, as a condition to subscription in the fund, plan investors adopt the manager’s voting policy.
  • The proposal has a 30-day comment period, meaning comments are due by early October.

Webcast Available Now – ESG Regulatory Lens – A Guide for Private Fund Managers

In this webcast, we:

  • Provide an overview of ESG and how the strategies apply to the various types of private fund managers.
  • Give an update on the regulatory climate and legal developments for ESG from the US to Europe and Asia.
  • Provide a framework for approaching the development of an ESG process, including where to access useful tools and resources.

Presenters:

Trysha Daskam, Director & Head of ESG Strategy, Silver Regulatory Associates

John P. Hamilton, Counsel, Stradley Ronon

George Michael Gerstein, Co-Chair, Fiduciary Governance, Stradley Ronon

Replay