The DOL Finalizes Yet Another Rule on ESG and Proxy Voting and Proposes Significant Amendments to the QPAM Exemption

The Department of Labor has been busy with various regulatory initiatives during 2022 and this trend is likely to continue into 2023.

This high-level overview of a couple of noteworthy DOL regulatory initiatives should be useful for boards and management teams alike.  The first  is a proposed amendment to a popular “prohibited transaction” exemption, which, if passed, will have a significant impact on many financial contracts, including existing loan and ISDA contracts.  The second is a final regulation governing ERISA plan investments, which could alter how plan investors consider ESG as part of their investment strategy and manage their investments in public companies.

The DOL’s Proposed Amendment to the QPAM Exemption

ERISA plan sponsors and service providers frequently rely on Prohibited Transaction Exemption 84-14 in connection with transactions involving ERISA plan assets.  By way of background, absent an applicable exemption, ERISA prohibits certain direct and indirect transactions (e.g., purchase/sale, extension of credit, provision of services) between ERISA plans and “parties in interest” with respect to such plans. Given the breadth of the term “party in interest,” ERISA plan sponsors and service providers frequently confirm the applicability of an exemption (e.g., the QPAM Exemption) instead of attempting to confirm that there is no “party in interest” relationship. 

In July of 2022, the DOL proposed an amendment to the QPAM Exemption that includes a number of key changes, which would fundamentally alter the way in which ERISA plan sponsors  and service providers rely upon this exemption.[1] One of the proposed changes would require review, and likely amendment, of nearly every agreement involving ERISA plan assets and referencing (or relying upon) the QPAM Exemption (including ISDAs, investment management agreements and loan agreements). After publication of the Proposal, the DOL received numerous comments from service providers and industry groups raising concerns regarding the impact of the Proposal and related issues.  As a result, the DOL held a public hearing in November 2022 and opened a second comment period, which closed.

At this time, it is difficult to predict with certainty what the final amendment will look like but it is unlikely that the DOL will abandon this initiative altogether. Further, the Proposal includes a relatively short timeframe for implementation of any required changes. Accordingly, ERISA plan sponsors and financial institutions that provide services to ERISA plans should consider surveying key agreements to get a better understanding of the potential impact of the Proposal from a resource/cost perspective. Depending on the substance of the final amendment, we may see less reliance on the QPAM Exemption across a broad range of transactions, which may require consideration of the applicability of other potential exemptions and could have a chilling effect on the willingness of service providers to enter into contracts with ERISA plans.  Compliance with the Proposal, if adopted, is likely to be costly to ERISA plan sponsors and service providers alike and the increased risk and cost of relying on the QPAM Exemption or alternative prohibited transaction exemptions could result in financial institutions and asset managers charging ERISA plans higher fees for investment management services and financial transactions.

ESG and Proxy Voting

In November of 2022, the DOL released its final rule^[2] clarifying the application of ERISA’s fiduciary duties to the selection of investments and investment courses of action.[3]

The Final Rule reaffirms a bedrock principle under ERISA’s duties of prudence and loyalty – when selecting investments and/or investment courses of action, plan fiduciaries must focus on the relevant risk-return factors and may not subordinate the interests of participants and beneficiaries to objectives unrelated to the provision of benefits under the plan (e.g., by reducing investment returns and/or increasing investment risks). Through the years, the DOL has issued quite a bit of guidance regarding the consideration of ESG factors and the exercise of shareholder rights. While the foregoing principle has remained constant, the DOL’s guidance has varied as to the degree to which ESG factors may be considered and the responsibilities of fiduciaries in connection with the exercise of shareholder rights.[4]  With the Final Rule, the DOL intends to “remove the chilling effect created by the prior administration on considering environmental, social and governance factors in investments”[5] and the Final Rule may make it easier for ERISA plan sponsors and their fiduciary committees to select investments (and/or investment options) with a nexus to ESG factors.   

As part of the Final Rule, the DOL:

• Clarified that fiduciaries may, without violating their duties of loyalty and prudence, take into consideration participants’ non-financial preferences when constructing a menu of investment options for participant directed (i.e., 401(k)) plans;
• Reemphasized that an ERISA fiduciary’s duties extend to the management of shareholder rights, including with respect to proxy voting; and
• Affirmed the duty to prudently select and monitor proxy voting advisory firms (and any other related service providers) -- an ERISA fiduciary may not adopt a practice of rubber stamping decisions made by any such service providers and such fiduciary must independently determine that the proxy voting guidelines utilized by such service providers are consistent with its fiduciary duties under ERISA.

While the Final Rule does not mandate the consideration of investments with a nexus to ESG factors (or provide blanket approval thereof), as part of routine ongoing monitoring and selection of plan investments, ERISA plan sponsors and their fiduciaries may want to consider such investments and, in the case of participant-directed plans (i.e., 401(k) plans), whether participants would prefer an investment line-up that includes such investments. In addition, any changes incorporated into an ERISA plan’s investment policies in response to the 2020 Final Rule should be revisited to ensure harmony with the Final Rule.

In addition, ERISA plan sponsors and their fiduciary committees should consider reviewing arrangements with proxy voting firms to ensure that the retention of such firm and such firm’s voting policies and procedures are consistent with ERISA’s fiduciary duties. In addition, an ERISA plan sponsor’s fiduciary committee should include, as part of its routine monitoring, a review of the services provided and votes taken by such firm and an analysis of whether such actions are consistent with applicable proxy voting policies and procedures. 

In Conclusion

ERISA plan sponsors and fiduciaries should continue to monitor these and other DOL initiatives over the coming year.

[1] 87 Fed. Reg. 45204 (July 27 2002).

[2] 87 Fed. Reg. 73866 (December 1, 2022).

[3] See our December alert memo for our summary of the Final Rule, available here.

[4] See Interpretive Bulletin, 94-1, 59 FR 32606 (June 23, 1994); Interpretive Bulletin, 94-2, 59 FR 38860 (July 29, 1994); Interpretive Bulletin 2008-01, 73 FR 61734 (October 17, 2008); Interpretive Bulletin 2008-02, 73 FR 61731 (October 17, 2008); Interpretive Bulletin 2015-01, 80 FR 65135 (October 26, 2015); Interpretive Bulletin 2016-01, 81 FR 95879 (December 29, 2016); Field Assistance Bulletin 2018-01, 85 FR 72846 (November 13, 2020); 85 FR 81658 (December 16, 2020) (the 2020 Final Rule); and Executive Order (E.O.) 13990, “Protecting Public Health and the Environment and Restoring Science to Tackle the Climate Crisis” (January 20, 2021).

[5] DOL news release: “US Department of Labor Announces Final Rule to Remove Barriers to Considering Environmental, Social, Governance Factors in Plan Investments” (November 22, 2022), available here.