The Biden Department of Labor (DOL) has published a series of pronouncements—revised regulations on ESG, a “Supplemental Statement” on private equity, a Compliance Assistance Release on “Cryptocurrencies,” and a request for information on “Climate-Related Financial Risk”—all raising or “clarifying” the ERISA fiduciary prudence issues with respect to specific investments that a retirement plan may make.
DOL Focuses on Prudent Investment as a Function of Investment Fundamentals
In much of the discussion with respect to the merits and demerits of these different investments, DOL’s analysis has focused on the valuation of different investments based on fundamental factors, such as discounted cash flow or the anticipated climate-related risk of the investment.
That sort of thing is, no doubt, how an investment analyst might go about valuing a company, and, presumably, how an active manager selects, e.g., which growth stock—out of the universe of growth stocks—it believes will outperform the average/benchmark.
But in a Liquid and Transparent Market, ERISA Simply Focuses on Fair Market Value/Stock Price
I do not believe that, at least with respect to securities traded in a transparent and liquid market, the analytical process being used by DOL has anything to do with ERISA prudence.
Consider the theory of the “random walk.” As explained by Investopedia: “[R]andom walk theory proclaims that stocks take a random and unpredictable path that makes all methods of predicting stock prices futile in the long run.” In other words, a stock’s price is as good a determination of its value as you can get.
And if the point about the utility of analyst’s theories isn’t clear enough here, the Wall Street Journal famously ran a contest pitting analysts against a portfolio picked by (literally) throwing darts (take that, discounted cash flows!). The analysts won 87-55 in 140 trials, but they only beat the Dow Jones average (a passive investment) in 76 trials. And that analysis was done (presumably) without consideration of/deduction for manager fees.
No one challenges the validity of some version of the random walk theory; it is fundamental to the passive investment theory now favored by many.
This theory—that a stock’s or bond’s fair market value equals its price in a transparent and liquid market—makes up one half of ERISA’s prudence requirement. The other half is a requirement that investments be diversified to avoid the risk of large losses.
The Supreme Court’s Dudenhoeffer Decision
If you don’t believe me, let me quote the (unanimous) opinion of the Supreme Court in Fifth Third Bancorp et al. V. Dudenhoeffer: “In our view, where a stock is publicly traded, allegations that a fiduciary should have recognized from publicly available information alone that the market was over- or undervaluing the stock are implausible as a general rule, at least in the absence of special circumstances.” Thus, FMV = price = prudence.
And while Dudenhoeffer involved company stock, the Court was at pains to point out that the special deal that company stock gets with respect to ERISA prudence only goes to the other half of prudence: diversification. The half of prudence we’re talking about here—the prudence of making any particular investment—simply goes off of whether you paid fair market value for it, as determined in a transparent and liquid market.
There Is Nothing in ERISA for or Against any Particular Investment
The foregoing requires, on the one hand, that no special attention (as, e.g., the Trump DOL would have had it) be paid to ESG investments, so long as they are made at a market price determined by in a transparent and liquid market. It also renders a little ridiculous all of the hand wringing (as the Biden DOL would have it) over the threat of climate change to investment returns.
Yes, some piece of an iceberg might, because of climate change, break off and destroy some oil company’s underwater rig. But as the Court said in Dudenhoeffer, it is implausible that the market has not already baked this threat into the price of the oil company’s stock.
Reconsidering DOL’s Pronouncements with a View to the Transparency and Liquidity of the Relevant Markets
Using the lens o fair market value = market price = prudence, let’s consider these recent DOL pronouncements one at a time:
ESG: In October 2021, DOL proposed a revision to prior (Trump adminstration) DOL regulations, backing off some of the negative language and eliminating some of the special requirements with respect to ESG investments. I think that is all a good thing, despite (as noted) a lot of rhetoric in the proposal about how important climate change is to stock performance. Per the Supreme Court, the idea that DOL has a better idea of the threat of climate change to investments than the market does is “implausible.”
Private Equity: In December 2021, DOL published a “Supplemental Statement on Private Equity in Defined Contribution Plan Designated Investment Alternatives.” I would say that the cautions about PE investments voiced by DOL in this announcement make sense. Since PE investments generally are not priced in a transparent and liquid market, PE valuation is problematic, as they say.
Crypto: In March of 2022, DOL published a “Compliance Assistance Release” (only the second in this genre of sub-regulatory guidance) on cryptocurrency investments in participant-directed DC plans. Setting aside DOL’s novel application of a robust prudence standard to brokerage windows and its “regulation by making threats” style of addressing the issue, its concern about the validity of pricing in crypto markets (again) makes some sense.
However, its explanation of why those concerns matter to ERISA prudence totally misses the point. It does not matter that “Experts … [note] that none of the proposed models for valuing cryptocurrencies are as sound or academically defensible as traditional discounted cash flow analysis for equities or interest and credit models for debt.” It does matter that these markets may lack the transparency and liquidity of stock and bond markets. How exactly do you explain the valuation of Tesla pursuant to such academic theories? In the end, the market price rules, regardless of what academics say.
Climate-Related Financial Risk: In February 2022 DOL published a “Request for Information on Possible Agency Actions to Protect Life Savings and Pensions from Threats of Climate-Related Financial Risk.” Notwithstanding that this CRFR RFI was only an RFI, it (like, e.g., the crypto Compliance Assistance Release) included a discussion of the issues presented under ERISA with respect to “climate-related financial risk” that is utterly at odds with ERISA’s principles. (I’m resisting the temptation to simply requote the Supreme Court here.)
Let me be as explicit on this point as I can: For purposes of determining ERISA prudence, ERISA does not recognize the possibility that DOL, or a court, is able to discern that the market has, e.g., undervalued the “climate-related financial risk” a particular investment presents. That doesn’t mean that an ESG investor can’t, e.g., in an actively managed fund, invest on that basis, that is, on the basis that the market has undervalued the “climate-related financial risk” of a particular stock. It just means that, for ERISA prudence purposes, you can’t pay anything more than the market price, for a stock traded in a transparent and liquid market.
To the extent that prudence requires anything other than diversification, that is all that ERISA requires. And on that basis, DOL has no business second-guessing your decision to buy or not buy that stock.
What, then, does ERISA’s diversification rule require, especially in the context of a participant directed DC plan? How might ERISA’s (separate) fiduciary duty of loyalty affect fiduciary decision making, e.g., with respect to ESG investments? And if these principles apply at the level of individual stock purchases, how do they apply at the fund level? These are questions that I would like to take up in a subsequent column.
The bottom line: The DOL should be focusing on the reliability of markets, not the virtue—or lack of it—of any given asset class or any particular stock.
Michael P. Barry is a senior consultant at October Three and President of O3 Plan Advisory Services LLC, which provides retirement plan regulatory analysis targeted at plan sponsors and those who provide services to them.
Opinions expressed are those of the author, and do not necessarily reflect the views of NAPA or its members.