Federal Court Backs DOL in ESG Rule Suit by Red State AGs

“Having considered the motions, pleadings, and relevant law,” a federal court judge has backed the Labor Department in a suit brought by 26 red state Attorneys General challenging the so-called ESG rule.

The coalition[i] that brought the suit in January 2023, alleged that the 2022 Rule “undermines key protections for retirement savings of 152 million workers—approximately two-thirds of the U.S. adult population and totaling $12 trillion in assets—in the name of promoting environmental, social, and governance (‘ESG’) factors in investing, including the Biden Administration’s stated desire to address climate change.” The rule—Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights—took effect Jan. 30, 2023.

The suit claimed that “the 2022 Rule oversteps the Department’s statutory authority under the Employment Retirement Income Security Act of 1974 (‘ERISA’), 29 U.S.C. § 1001 et seq., and is contrary to law”—and comments that “the 2022 Rule is also arbitrary and capricious.”

American Retirement Association CEO and NAPA Executive Director Brian Graff applauded the ruling, stating that the “ARA supports this decision and believes the DOL struck the right balance in the final rule when giving plan fiduciaries the discretion to decide whether ESG factors were relevant when evaluating retirement plan investments.”

The Standard

“The question of whether the Rule violates ERISA invokes the analytical framework outlined in Chevron USA Inc. v. Nat. Res. Def Council, Inc., 467 U.S. 837 (1984),” noted United States District Judge Matthew J. Kacsmaryk. He went on to explain that framework’s two steps; first "whether Congress has directly spoken to the precise question at issue," in which case, courts "must give effect to the unambiguously expressed intent of Congress and reverse an agency's interpretation that fails to conform to the statutory text”—and secondly, if the statute is ambiguous, the court “may not disturb an agency rule unless it is ''arbitrary or capricious in substance, or manifestly contrary to the statute." 

Judge Kacsmaryk noted (Utah v. Walsh, N.D. Tex., No. 2:23-cv-00016, 9/21/23) the plaintiffs argue that DOL loses at either step because "the plain text of ERISA forecloses consideration of non-pecuniary factors, including for tiebreakers." That didn’t carry much weight with Judge Kacsmaryk, who said that wasn’t the case here “because ERISA does not contemplate the possibility of a ‘tie’ between two financially equivalent investment options, Congress has not ‘directly spoken to the precise question at issue.’” He also held that “DOL also wins at step two. That is because the reasonableness of DOL's interpretation is supported by its prior rulemakings—including the 2020 Rule which Plaintiffs approvingly hold out as ‘reflect[ing] ERISA's focus on financial benefits.’"

“Indeed”, Judge Kacsmaryk continued, “since at least 2015, DOL has posited that ESG factors ‘may have a direct relationship to the economic value of the plan's investment.’ And likewise, the 2020 Rule stated that failing to consider ESG-related risk-return factors could constitute a violation of the duty of prudence in some circumstances”—he noted that the plaintiffs “concede that ESG factors can be considered or risk-return purposes in appropriate circumstances.”

‘Little Meaningful Daylight’

He explained that “the 2022 Rule changes little in substance from the 2020 Rule and other rulemakings.  Where the 2020 Rule explained that collateral factors may be considered when a fiduciary is ‘unable to distinguish’ between two investment options based on financial factors alone, the 2022 Rule allows the same when the two options ‘equally serve the financial interests of the plan.’" He continued, “And while Plaintiffs aver that the 2022 changes loosen restrictions on fiduciaries, there is little meaningful daylight between ‘equally serve’ and ‘unable to distinguish.’" The Rule also explains that fiduciaries remain free "to determine that an ESG-focused investment is not in fact prudent.”

“Additionally, the Rule's statement that risk return factors ‘may include’ ESG factors differs from the ‘may often require’ language of the proposed rule,” he observed. “As DOL clarified, the proposed language ‘was not intended to create an effective or de facto regulatory mandate’ or ‘an overarching regulatory bias in favor of ESG strategies.’ To the contrary, the Rule ‘makes unambiguous that it is not establishing a mandate that ESG factors are relevant under every circumstance, nor is it creating an incentive for a fiduciary to put a thumb on the scale in favor of ESG factors.’"

“To summarize, an ESG factor could be worth consideration even under prior rules if it ‘is expected to have a material effect on the risk and/or return of an investment.’ Similarly, the 2022 Rule states that risk and return factors may include ESG factors under some circumstances, but those factors must still reflect ‘a reasonable assessment of its impact on risk-return.’" He continued, “in other words, the 2022 Rule ‘'provides that where a fiduciary reasonably determines that an investment strategy will maximize risk-adjusted returns, a fiduciary may pursue the strategy, whether pro ESG, anti-ESG, or entirely unrelated to ESG.’"

“Thus, after affording DOL the deference it is presently due under Chevron, the Court cannot conclude that the Rule is "manifestly contrary to the statute," he added.

APA Review

As for whether the rule is “arbitrary or capricious under the Administrative Procedures Act (APA), Judge Kacsmaryk noted (citing legal precedents) that “the scope of review under the arbitrary and capricious standard is narrow and a court is not to substitute its judgment for that of the agency,” that “courts should recognize that agencies ‘have expertise and experience in administering their statutes that no court can properly ignore,’” but that “the agency must nevertheless ‘examine the relevant data and articulate a satisfactory explanation for its action including a rational connection between the facts found and the choice made.’"

Judge Kacsmaryk commented that the plaintiffs had argued that “(1) the Rule does not rebut DOL 's prior finding that ‘strict’ regulations are necessary; (2) the alleged need for the Rule is inadequate because DOL never identified ‘'who specifically was confused,’ the ‘source of confusion’ or that ‘any such confusion or negative perceptions reduced financial returns for participants and beneficiaries’; and (3) many of the Rule's provisions are ‘unreasonable, internally inconsistent, fail to consider relevant factors,’ and rely on factors ‘Congress has not intended it to consider.’"

Once again, Judge Kacsmaryk brushed aside those arguments. “These arguments all fail to establish an APA violation,” he wrote. “To begin, DOL explained its position that the 2020 Rule had a chilling effect on fiduciaries' consideration of pertinent information when making investment decisions. And DOL expressly replied to comments that argued the agency ‘did not articulate what confusion it had created.’  The Department identified specific comments speaking to that issue, cited literature from the Harvard Law School Forum on Corporate Governance and the United Nations Principles for Responsible Investment, id., and considered eliminating the tiebreaker test before ultimately retaining it due to reliance interests.” Judge Kacsmaryk said that despite assertions of the plaintiffs that references to taking into account participant preferences were really a euphemism for considering nonpecuniary factors—those would, in any event, be trumped by clarification in the final rule that "fiduciaries may not add imprudent investment options to menus just because participants request or would prefer them."

Alternative Arguments

In like fashion, Judge Kacsmaryk dispensed with a series of alternative arguments the plaintiffs put forth, including concerns about the deletion of the prohibition on proxy voting rights to promote goals unrelated to financial interests (already required of fiduciaries), the elimination of specific restrictions on QDIAs (already subject to requirement to focus on financial interests), the removal of a disclosure requirement when a fiduciary considered a collateral benefit (was seen as inherently ambiguous, unnecessary, etc.), as well as why the Labor Department wouldn’t simply continue to rely on sub-regulatory guidance (wouldn’t have muted the “chilling effect” of the 2020 rule).

“For all these reasons, the Rule does not violate the APA. And while the Court is not unsympathetic to Plaintiffs' concerns over ESQ investing trends, it need not condone ESG investing generally or ultimately agree with the Rule to reach this conclusion,” Judge Kacsmaryk concluded. “Rather, ‘all that is necessary is a 'minimal level of analysis' from which the agency's reasoning may be discerned’ ‘regardless of whether the court finds the reasoning fully persuasive.’"

“DOL has provided that here. Accordingly, the Department is entitled to summary judgment, and Plaintiff's Motion must be denied,” Judge Kacsmaryk ruled.

What This Means

Judge Matthew J. Kacsmaryk—who had been appointed by President Trump—seemed to be a friendly venue[ii] for the suit brought by 26 States and other interested parties challenging the United States Department of Labor and the Secretary of Labor in his official capacity over the "2022 Investment Duties Rule." But it appears that Judge Kacsmaryk actually read the final rule, rather than a proposed version that preceded it. 

In contrast, most of the arguments presented in the suit—filed mere days before the regulation was to take effect—seemed grounded in positions taken in the Biden Administration’s proposed rule that was arguably more pro-ESG than what found its way into the final text. 

In Judge Kacsmaryk’s words, there’s arguably “little meaningful daylight” between the final rule left by the Trump Administration (in fairness, their proposed rule was a lot more anti-ESG than the final) and that of the final Biden Administration rule[iii] (which, in fairness, was less pro-ESG than their proposal).