Texas federal court upholds DOL’s ESG investing rule

State of Utah v. Walsh
Date: Sept. 21, 2023

Issue: Whether the Department of Labor’s (DOL) final rule on the use of environmental, social and governance (ESG) considerations by fiduciaries in their investment decision-making (2022 rule) violates the Administrative Procedure Act and the Employee Retirement Income Security Act of 1974 (ERISA).

Case Summary: A district judge in the Northern District of Texas upheld the Department of Labor’s new ERISA regulations on environmental, social and governance (ESG) investing.

In 2020, DOL issued regulations (the 2020 rule) indicating ESG factors may only be considered in a tiebreaker situation where fiduciaries are unable to distinguish between investments on the basis of pecuniary factors alone. The 2020 rule also imposed a stringent documentation requirement where ESG factors were employed. In subsequent comments received by DOL in response to the 2020 rule, commentators expressed confusion over whether ESG factors could ever be considered financially material.

To address these concerns, the DOL issued the 2022 rule clarifying ERISA fiduciaries may take into account ESG factors relevant to an investment’s expected risk-return, restating the ESG tiebreaker rule, but not to obtain collateral benefits. The 2022 rule also eliminated special requirements concerning the selection of qualified designated investment alternatives, and also the monitoring and recordkeeping requirements with respect to proxy voting.

A coalition of states sued DOL in January 2023, alleging the 2022 rule is arbitrary and capricious under the APA because, among other things, the DOL ignored relevant considerations and failed to consider alternatives. The states also alleged the 2022 rule promoted ESG investing at the expense of retirement plan beneficiaries by allowing fiduciaries to choose an investment based on “collateral benefits,” rather than requiring fiduciaries to act “with the sole motive of promoting the financial interests of plan participants and their beneficiaries” under ERISA Section 404(a)(1)(A).

Judge Matthew J. Kacsmaryk of the Northern District of Texas, (a Trump appointee), ruled the 2022 Rule is consistent with ERISA and a reasonable exercise of the DOL’s rulemaking authority. The court analyzed the 2022 Rule under Chevron’s two-step framework. At the first step, courts analyze whether Congress has directly spoken to the question at issue. If so, Congress’ directive is controlling. But if the court determines Congress has not directly addressed the precise question at issue, the court should not impose its own construction on the statute, and instead the court should move to step two. At the second step, courts analyze whether the agency’s interpretation is based on a permissible, or reasonable, construction of the statute. If so, the court must defer to the agency’s interpretation.

Applying Chevron, Judge Kacsmaryk determined the DOL prevails at both steps. First, because ERISA does not contemplate the possibility of two financially equivalent investment options, the court determined Congress has not spoken to the question at issue. Second, the court concluded DOL’s interpretation in the 2022 rule is reasonable. In reaching its decision, the court pointed to DOL’s prior rulemakings. Under the prior rules, “an ESG factor could be worth consideration if it is expected to have a material effect on the risk/return of an investment.” The court explained under the 2022 rule, 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.” As described by the court, there is “little meaningful daylight” between the old and new tiebreaker provisions, because “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.”

The court also ruled DOL’s rulemaking was not arbitrary and capricious. The court found that the DOL adequately explained the reasons for its rule changes, including the purported chilling effect the 2020 rules had on fiduciaries’ consideration of pertinent information when making investments. The court also determined the DOL fulfilled its duties to “consider the alternative of issuing sub-regulatory guidance instead of amending the regulation itself.”

Bottom Line: Although the DOL initially expressed skepticism over the venue and requested a change—which was rejected—Judge Kacsmaryk found for the agency. Meanwhile, a separate lawsuit challenging the 2022 rule, filed by two individual plan participants in the Eastern District of Wisconsin, Milwaukee Division, is still ongoing

Document: Opinion