Paul L. Caron

Friday, January 7, 2022

Weekly SSRN Tax Article Review And Roundup: Roberts Reviews Zelinsky's The Proposed Regs On ESG Investing

This week, Tracey Roberts (Cumberland; Google Scholar) reviews a new work by Edward A. Zelinsky (Cardozo), Comments to the Department of Labor Proposed ERISA Regulations, “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,” amending and restating 29 CFR §2550.404a-1.

Roberts (2020)

The Employee Retirement Income Security Act of 1974 (ERISA) protects retirement plan participants and beneficiaries in a variety of ways. Under ERISA, pension plans must meet certain standards with respect to (i) participation, identifying who may participate, (ii) vesting, establishing how long those individuals must work to receive retirement funds, (iii) funding, determining the minimum amount of funds that must be set aside to pay future plan participants, (iv) management, requiring fund managers to adhere to a fiduciary standards, handling funds prudently and in the best interests of plan participants, and (v) disclosure, requiring plan managers to inform participants of their rights and the financial status of the plan. The Department of the Treasury and the Internal Revenue Service oversee plan participation, vesting, and funding. Participants in qualifying plans enjoy tax deduction and deferral benefits. They also retain the right to sue to recover earned benefits. The Department of Labor regulates fiduciary standards and requirements for reporting and disclosure of financial information.

Recently, the Department of Labor has proposed a change to the ERISA rules to clarify the plan fiduciaries’ investment prudence duties and safe harbor against participant and beneficiary lawsuits, to permit plan fiduciaries to include the economic effects of climate change and climate risks and other environment, social or governance (“ESG”) considerations in choosing plan investments, and to clarify fiduciary duties regarding proxy voting and shareholder rights.

Professor Zelinsky argues that the proposed regulations are flawed in four ways: (i) by embracing the ESG label the regulations misapply the prudence standard because ESG is too new and unproven to be considered prudent, (ii) the ESG label is ambiguous and too imprecise to provide guidance to ERISA fiduciaries, (iii) the regulation should be drafted in a more even-handed way to avoid misunderstanding of ERISA’s fiduciary requirements, and (iv) the regulations further liberalize the “tie-breaking” or “all things being equal” rule, which he views as undermining the strict duties of loyalty and prudence and encourage ERISA fiduciaries to pursue collateral third-party benefits to the detriment of those duties. Professor Zelinsky has testified before the Senate to express his concerns about the “tie-breaking rule” and has written extensively about those concerns both at the time the rule was first proposed in 1994, in connection with Economically Targeted Investments, and more recently in 2015, when the Department of Labor issued non-regulatory guidance in the form of an Interpretive Bulletin.

While both the 2015 interpretive guidance and the currently proposed rules underscore that ERISA fiduciaries may not sacrifice investment returns or assume greater investment risks as a means of promoting collateral social policy goals, and stress that their paramount focus must be the plan’s financial returns and providing promised benefits to participants and beneficiaries, Professor Zelinsky is concerned that the guidance steers fiduciaries away from these requirements and leads them to violate their duty of loyalty. He notes that the U.S. Supreme Court has confirmed unanimously that ERISA requires fiduciaries to pursue financial benefits. Professor Zelinsky argues that the stringent duties of loyalty and prudence under the ERISA statute demand that fiduciaries must exclusively and prudently pursue “pecuniary” benefits for plan participants and beneficiaries. His language mirrors the language set forth in the final rule developed and published in the waning days of the Trump Administration, “Financial Factors in Selecting Plan Investments,” 85 FR 72846 (Nov. 13, 2020). That rule amended ERISA Investment Duties regulations to require that plan fiduciaries select investments and investment courses of action based solely on consideration of “pecuniary factors.” The 2020 regulations raised questions among plan fiduciaries about whether climate change and other ESG characteristics can be considered “pecuniary.”

Professor Zelinsky argues that it is economically implausible that ESG investing should outperform efficient markets. According to the efficient-markets hypothesis, stock prices reflect true fair market value in public exchanges. Setting aside the fact that the empirical evidence has generally not supported the efficient-markets hypothesis, there are two important reasons that fiduciaries may want to consider climate change and other ESG factors. First, our markets are subject to a massive global market failure. Currently, corporations, pension funds, and the banking, financial, insurance, and real estate markets are systematically failing to account for the economic and financial risks of climate change. Furthermore, until the United States begins to account for and internalize the externalized costs of fossil fuel use, no goods that are harvested, extracted, produced, manufactured, distributed, transmitted, transported, or consumed using fossil fuels will reflect their true value. Plan fiduciaries should be permitted to take into consideration the physical and transition risks of climate change, and the financial benefits and long-term alignment of investments in climate-adaptive technologies and climate-resilient infrastructure. Analyzing climate change risks and opportunities is considering pecuniary factors.

Second, the efficient-markets hypothesis is subject to problems of cognitive biases, including overconfidence, overreaction, and errors in reasoning and processing information. The mortgage crisis and Great Recession were caused by systemic risk that arose from “group-think” prevalent in the largely homogeneous financial services industry around financial models and valuation. For this reason, fiduciaries may want to consider whether firm management and other governance structures have been employed to counter these effects. Examining initiatives to promote diversity, equity and inclusion as a means to broaden markets and avoid systemic risks is considering pecuniary factors.

Professor Zelinsky is correct, however, in his statement that the ESG label is ambiguous and may lack substance. Following Europe’s announcement of funding for the Green Deal, the EU plan to recover from the global pandemic and address the threat of climate change at the same time, European financial markets have seen a flood of old interests and new entrants claiming that they are “green,” “sustainable”, “low carbon,” or that they employ ESG criteria. Numerous for-profit accounting firms and nonprofit organizations have developed private-governance solutions to engage the financial sector in the green transition by providing assessments of a firm’s ESG data. Organizations performing this work include the Global Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB), International Integrated Accounting Council (IR), and the Climate Disclosure Standards Board (CDSB). More recently, the Rocky Mountain Institute, through their Center for Climate-Aligned Finance, has begun developing a framework to encourage collaboration among the financial sector, its corporate clients, and policymakers. While there may be some correlation between long-term financial performance and reports of stronger ESG data, these reporting systems have seen a number of high-profile, high-cost failures. As Yale Professor Dan Esty reports in his book, Values at Work, British Petroleum (BP) had incorporated policy statements and a third-party sustainability review by 2010, but these efforts were not enough to give BP officers, directors, or investors notice of the risks that led to the Deepwater Horizon catastrophe.

Vanderbilt Professor Mike Vandenbergh has shown that private environmental governance has forged a pathway through regulatory ossification and gridlock, extended the reach of U.S. environmental regulation throughout the world via supply chains, empowered communities at the state and local levels, and given individuals a stake in addressing environmental problems. Private governance may also have bought us time in the fight against climate change. Nevertheless, private governance systems may also lack rigor and transparency and have inadequate monitoring and enforcement processes. Some have been labeled as forms of "greenwashing," marketing ecological engagement to the public and while providing cover for unsustainable operations.

Fortunately, in March, Europe began to implement the Sustainable Finance Disclosure Regulation to counter greenwashing and alter the way the investment management industry operates. In September, the U.S. Securities and Exchange Commission announced that it is considering more stringent disclosure requirements for investment funds with respect to ESG claims. At the very least, the Department of Labor may want to delay their decision in finalizing the current regulations until after the SEC has completed its review and, possibly, proposed regulations to delineate what counts as an ESG investment and what is merely greenwashing.

Here’s the rest of this week’s SSRN Tax Roundup:

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