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In this Ropes & Gray podcast, asset management partner Eve
Ellis and ERISA & benefits partner Josh Lichtenstein discuss
the recent DOL rule on ESG investing, and how managers should think
about integrating these new DOL rules alongside similar but
sometimes competing rules that have come out in the EU.
Transcript:
Josh Lichtenstein: Hello, and thank you
for joining us today on this Ropes & Gray podcast. I’m Josh
Lichtenstein, an ERISA partner based in our New York office.
Joining me today is Eve Ellis, a partner in the asset management
group based in London, who focuses on European regulatory matters
for fund managers. In this podcast, we’re going to be covering
the recent DOL rule on ESG investing and how managers should think
about integrating these new DOL rules alongside similar, but
sometimes competing, rules that have come out in the EU.
So Eve, as I think about these issues, I really focus on the
fact that while the DOL recently finalized its new rule on
investment decisions that will require private retirement plans and
asset managers to change how they approach ESG-focused investments,
they also need to think about the existing framework that’s of
course been out there, including the EU rules. The main takeaway in
my mind from the new DOL rule is that ERISA plans may still make
ESG investments, but they have to focus exclusively on material
pecuniary factors in making their investment selections. The term
“pecuniary factors” is a new term in the lexicon in this
space, and the most important thing to take away from that is that
it requires that you’re considering material economic factors,
not just economic factors. Outside of very rare
“tiebreaker” scenarios where two otherwise equivalent
investments are being considered, ESG factors can really only be
considered when they’re financial factors, and they also must
be weighted appropriately based on the expected impact of those
factors on the investment being evaluated. And so as a practical
matter, this means that ESG integration funds and funds which
incorporate ESG as part of their return driving strategy, or as a
factor to drive investment returns and diversification, will be
easier for an ERISA plan to select than an impact fund or another
type of fund that describes itself as being focused more on
promoting social good or creating other collateral benefits in the
world, in addition to driving investment returns. The new rule also
prohibits using ESG funds as the default investment options for
401(k) plans in most cases, and that’s significant because we
know as a matter of behavioral economics, 401(k) plan participants
are most likely to keep their assets invested in the default
investment. Eve, what is your reaction to the DOL’s new rule
and its singular focus on economic factors in evaluating ESG, from
the perspective of an EU regulatory lawyer thinking about how an EU
fund would seek to comply with those rules?
Eve Ellis: Thanks, Josh. Taking a step
back, it’s worth, for those who are less familiar with the EU
rule, just giving a really high-level overview of them. So
there’s two impending regulatory changes in relation to ESG and
the EU. The first is the Sustainable Finance Disclosure Regulation
(or SFDR), and the second is the Taxonomy Regulation. The SFDR
probably is more pressing because that comes into force next March,
and it also has broader scope. Very broadly, the SFDR will capture
all managers that have a presence in the EU, but it will also
capture managers that just market their products in the EU, so even
if they don’t have a regulated entity in the EU. They may also
have an indirect impact for managers that act as sub-advisers or
portfolio managers to EU-regulated entities. The other important
point to bear in mind is that the SFDR impacts all products, not
just those that have an ESG focus or sustainable objective. The
Taxonomy Regulation, on the other hand, is only relevant if you
have a fund that does have an ESG or sustainable objective. The
regulations require disclosure, particularly SFDR, and the
disclosures are relevant at both the manager level and the product
level. Very broadly, particularly the SFDR, and I’ll mention
this probably more because it is more pressing and has a broader
scope, require managers to have policy and procedures in place that
demonstrate how they integrate sustainability risk factors into
their investment decision-making process, but also in relation to
other operational aspects of their business, for example,
remuneration policies.
So my response and reaction to the DOL rule is that I think that
there is going to be a tension there – the EU will require
you to integrate sustainability risks into your investment
decision-making process, and other parts of the operations. I think
there is therefore a tension to the extent that those factors
don’t necessarily have a financial driver or financial criteria
attached to them. And I think that tension is compounded for
products that do have an ESG focus or sustainability objectives
because for those funds, there’s even more requirements in
relation to disclosure that apply, and so I think that is certainly
something that managers are going to have to balance in how they
deal with the two slightly competing regimes.
Josh Lichtenstein: It’s very
interesting, Eve, because as you talk about the EU rules and about
the way that they apply more broadly than just to ESG-focused
funds, it’s actually very similar to the DOL’s rule,
because the DOL’s rule, in fact, doesn’t even mention the
words “ESG” in the final text, but similar to what you
were just describing, it definitely does hit ESG funds more
directly and creates more burdens.
But when I think about ESG from an ERISA perspective, the thing
that I always come to is marketing materials. The new DOL rule will
put a lot of pressure on asset managers to make sure that
they’re being reasonable and accurate in how they describe
their ESG claims, and it’ll be important to tell the economic
story behind your ESG philosophy. This is true for any fund that
may market to an ERISA plan, regardless of whether that fund is
expected to hold plan assets or not, and so managers who are used
to not really thinking about ERISA that much, like mutual fund
managers, actually need to be prepared to make adjustments based on
this rule if they want to be able to market to ERISA plans. I think
that this draws on a lot of important themes in the ESG
marketplace, like how you measure the economic impact of ESG
factors, greenwashing and ESG integration more broadly. I can
easily imagine a manager being in the room for a pitch, and that
pitch, which is otherwise going well in front of an ERISA plan
sponsor, becomes derailed when the presenters turn the page on
their slide deck and they realize that they’ve included a
generic slide on the ESG philosophy of the manager that includes
broad philosophical claims, instead of something that’s more
detailed and targeted about how ESG is being incorporated for that
specific fund in order to drive good returns for that fund. Do you
have similar concerns about marketing materials under the EU
rules?
Eve Ellis: Yes, greenwashing certainly is
one of the key components – it probably is at the heart of a
lot of the EU regulation, particularly the Taxonomy Regulation, and
making sure a fund does what it says it’s going to do and that
investors are making informed decisions about what products to
invest in. So trying to reduce greenwashing, really, is a key part
of the regulation. Therefore, a manager can’t put bold
statements in its marketing materials and not be able to deliver or
to explain to investors how they actually intend to meet those
objectives. There’s particular provisions in the SFDR, for
example, that say that you’re not allowed to have inconsistent
marketing materials, so if you say something in your disclosure,
that needs to be reflected in your marketing documentation –
I think that’s a really key part of the EU regime. One thing
that’s worth bearing in mind, particularly for ESG-focused
funds, both under SFDR and under the Taxonomy Regulation, you will
need to clearly disclose how you intend to meet the objective that
you set out that are either part of the E, S or G or the
sustainable objectives that your fund is meant to be achieving. And
the Taxonomy Regulation also goes further than that, and says that
you will need to disclose that you’re not going to do
significant harm to certain criteria that are set out in the
Taxonomy Regulations. So Josh, I think that’s completely right
– that really is a key part of the EU regime.
Josh Lichtenstein: Interesting. You
mentioned disclosure, and of course, as lawyers, we spend a lot of
time thinking about and talking about disclosures and helping our
clients with them. From the DOL standpoint, my main concerns about
disclosure are actually pretty similar to what I was mentioning
about marketing. It’s important to be focused and targeted in
describing how you’re going to use ESG factors in your
investment process, but this may be difficult when managers want to
have uniform disclosure, whether it’s going to appear on the
website or in some sort of government-mandated or
regulatory-required disclosure. I’ve had a lot of conversations
about this with clients who are trying, understandably, to have a
single global ESG policy, and then they run into issues when they
need to apply that policy to funds that are being targeted towards
ERISA plans. When I talk to clients about this, my advice has
generally been that they really either will need to limit the way
that they describe ESG in their global policies or try to change
the slant or phraseology used to deemphasize the non-financial
considerations, or have a separate U.S. policy or policy rider,
although that isn’t always ideal for global managers. Eve,
I’d be curious to hear if you’ve had similar conversations,
and how you’ve been thinking about these different types of
challenges in advising our clients?
Eve Ellis: Yes, I definitely agree, the
integration across different geographies, across different
requirements and different rules is really important for people
that are listening and for our clients because it’s really
important that as far as we can, policies are integrated, and so I
think trying to look at the DOL rules, the EU rules and even
investor requirements and requests is key. Thus can’t be done
in a vacuum – they really do need to be looked at across the
different rules because ESG just permeates so much of the business.
So I think one of the things that we’re saying to clients when
it comes to the EU piece is, we need to look at the EU piece, we
need to do a clear scoping exercise and gap analysis, look at the
requirements, but a really important aspect of your SFDR road map
is working out how it integrates across the different requirements,
so that if you have ERISA investors are part of your investor base,
we do try and address as far as we can the DOL requirements. As
many investors have been driving for many years, even before the
regulatory change, ESG is a clear focus for most, and so making
sure that both requirements are built into any policy that is put
in place to deal with SFDR – and as I say, not looking at it
in a vacuum, I think, is so important. The other thing that I would
say is that SFDR has “disclosure” in the name, and
disclosure is key, but a lot of the disclosures relate to
underlying policies and procedures. So it’s not going to be
sufficient from an EU perspective to put the disclosure on the
website, necessarily. There will need to be policies and procedures
that back up those disclosures, and I think that’s probably the
key part of the implementation process. So for those managers that
are listening that have got more complex global structures with
different regulated managers and with different types of products,
that scoping exercise, and then looking at how it integrates across
the business as a whole, I think is really important.
Josh Lichtenstein: Yes, that’s such an
interesting aspect of all of this. There are these conversations
that we would have historically thought of as being isolated to
just one geography or one segment of the market, and now we’re
thinking of them on more of a global basis. I think that a trend
that’s going to endure and be accelerated by all these types of
rules is that more and more of what we do is becoming global. But
another place where I think that it’s interesting to think
about is differentiation among different types of targeted
investors, and as I mentioned before, different types of plans in
the U.S. will actually react to the DOL’s rule in different
ways. For a traditional defined benefit pension plan, the rule will
mostly influence what their investment diligence process looks like
and how they document the process. So if you’re trying to sell
a product to one of these investors, it’s very important to
focus on what you’re presenting to the committee, to the
fiduciary, to make sure that the fiduciary is able to easily
document how they went through the appropriate process under these
rules and weren’t unduly influenced by non-financial ESG
aspects of the investment or other non-financial aspects. But for a
participant-directed contributory plan, like a 401(k) plan, the
rule will actually be fairly different because it will likely
result in ESG options having to be selected to be alternatives to
other similar funds on an investment lineup, but very few ESG funds
being incorporated in any way into the default investment. As I
said before, that has direct ramifications for the amount of
dollars that you can expect plan participants to allocate to these
products. For the state-sponsored plans, which are obviously very
large investors in private funds, the impact is less direct because
the rule doesn’t actually apply to them. But the rule does
influence how ERISA fiduciaries act, and it’s very common for
these state plans to ask an asset manager to agree by contract to
act like it’s an ERISA fiduciary when managing assets on the
state plan. If that’s the case, then the rule likely would
influence the investment process, unless there’s an explicit
contractual carve-out saying that a manager agrees to act as if
it’s an ERISA fiduciary, but the avoidance of doubt will not be
required to comply with the new ESG rules. Eve, do you think the
different classes of investors will need to be treated differently
under the EU regime?
Eve Ellis: The EU rules don’t
distinguish between investors, Josh, so there’s no specific
requirement that you’ll need to treat different investors in
different ways. The one point I would make, though, is that some
investors have their own requirements, there are some additional
rules that will impact listed institutional investors, for example.
So they will need to be able to comply with their own regulatory
obligations when it comes to ESG. Also, there may well be some
institutional investors that themselves are regulated, and
therefore subject to the SFDR and Taxonomy Regulation. So that may
have an impact on how they interact with the managers, but the
rules themselves, the SFDR and Taxonomy Regulation, don’t
distinguish between investors in the same way as I think you
described.
Josh Lichtenstein: Interesting. So far
we’ve been talking, and there’s been, I think, a lot of
confluence in framework, although a lot of the substance is
different. This is a place where the framework is also fairly
different. Turning to a slightly different topic, I know I’ve
had some difficult conversations with clients about some hard
choices that they’re evaluating based on all of these new rules
that are coming out. I’ve seen clients that were planning on
offering some ESG-focused funds that would be targeted at ERISA
plans, and I have seen them abandon those. I’ve also seen
clients consider starting separate funds just for their ERISA
investors so that they could have very clear separations in the way
that the marketing gets handled and the way the investment process
weights ESG factors for the different products. I’ve seen
clients consider how they could change the descriptions of their
ESG diligence process or ESG philosophy based on the DOL rule, even
though that doesn’t necessarily align with what they’d like
to do from a business standpoint. Eve, have you had similar hard
conversations with clients, seeing them take steps to comply with
rules, which may not really align with their business goals?
Eve Ellis: Not yet. I think with the EU
rules, particularly the SFDR, they’re still evolving and
we’re still waiting for guidance, and there are certain
standards that have been postponed that I think will see where they
settle in terms of how prescriptive and burdensome some of the
rules are to comply with. So I haven’t seen managers have to
make those hard decisions as to whether they want to deemphasize
ESG factors, even if they don’t want to from a business
perspective, but I do worry that that could happen, which clearly
is not what the policymakers intended. But to the extent that these
rules become so prescriptive and become difficult to comply with
and go beyond what the manager is choosing to do, given its
investment objectives, strategy, and given its investors, I worry
that there could be a shift – and I’ll just say, that
that’s clearly not what was envisaged.
Josh Lichtenstein: It’s interesting to
hear, Eve, that there’s been, even though the EU rules may be
actually more fleshed out in some ways than DOL’s rule is and
maybe broader in scope, it seems like there’s already been some
more concrete, hard decisions that have had to be made by some of
our U.S. managers or our global managers, thinking about marketing
to ERISA plans under the DOL rule. So as our global asset manager
clients and our EU-focused asset manager clients are thinking about
all these different issues, if there was just one takeaway that you
would leave them with. what would it be?
Eve Ellis: Thanks, Josh. If I can be
cheeky and take two takeaways. I think the first takeaway is, from
an EU perspective, now is the time to take action in terms of
considering how the EU rules are going to impact your business and
your products. The rules come into force on the tenth of March next
year, as I’ve mentioned, and I think particularly for people
that are listening that have got more complex, global structures,
it’s really important that you start thinking about the EU
rules and how they interact across your business, and other rules.
I think the other takeaway is how managers integrate the DOL rule
and the EU rule is really important. And I think one of the
takeaways is that if this is carefully considered, it can be
achieved. While the DOL rule is looking at ensuring that you put
weight on financial criteria and financial factors, and the EU rule
is saying that you need to integrate sustainability risk into your
investment decision-making process, it doesn’t say that you
can’t put weight to financial criteria. I think there are ways
that the two can be considered, but I think it does need careful
consideration and it needs to be balanced against the DOL
requirement that these factors carry financial or economic weight
as well as ESG consideration.
Josh Lichtenstein: Those are both really,
really great points, and I agree completely. I think that
there’s somewhat of a tightrope, but that doesn’t mean that
it can’t be walked – just have to be very, very careful
in making sure that you’re meeting your obligations under the
EU rules without running afoul of prohibitions under the DOL rule.
Thank you, Eve, for joining me for this really interesting
discussion. And thank you to our listeners. For more information on
the topics that we discussed today, or any other topics of interest
to the global asset management community, please visit our website
at www.ropesgray.com. Of course, we’d be
happy to navigate any of the topics we’ve discussed, so please
don’t hesitate to get in touch. You can also subscribe or
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