Deep Dive Episode 122 – New Labor Department Rule: Taking on ESG Investment Risk to American Retirement Security

A sustained effort by activist investors to align corporate policy and investing with a progressive policy agenda could be shortchanging the retirement savings of millions of Americans. Data show that investments tied to perceived environmental, social, and governance principles, or ESG, generally offer lower yields than the S&P 500 benchmark, but activists are pushing to use trillions of dollars in pension and retirement plans to discriminate against various industries. The trend could have profound implications for public and private pensions programs and other retirement savings plans. ESG investing might also pose a challenge to the fiduciary responsibility of asset management professionals to act in the best financial interests of the people they serve, a bedrock concept in financial planning.

The U.S. Department of Labor is preparing to ensure ESG investing does not undermine protections enshrined in the Employee Retirement Income Security Act (ERISA). A proposed rule would codify in law that asset managers must uphold their fiduciary responsibility when considering ESG investment decisions. The rule states: “It is unlawful for a fiduciary to sacrifice return or accept additional risk to promote a public policy, political, or any other nonpecuniary goal.” A comment period ends on July 30.

In this live podcast, J.W. Verret discusses the Labor Department’s proposed rules and their implications for retirement security.


Although this transcript is largely accurate, in some cases it could be incomplete or inaccurate due to inaudible passages or transcription errors.

Nick Marr:  Welcome everyone to The Federalist Society’s Teleforum conference call. This afternoon will be a discussion on “A New Labor Department Rule: Taking on ESG Investment Risk to American Retirement Security.” My name is Nick Marr. I’m Assistant Director of Practice Groups at The Federalist Society.


And as always please note that expressions of opinion are those of the expert on today’s call.


Today we’re fortunate to have with us here Professor J.W. Verret, Associate Professor of Law at George Mason’s Antonin Scalia Law School. After our speaker gives his opening remarks, we’ll then go to audience Q&A. So be prepared and have those in mind for that portion of the call. Thanks for sharing with us today, Professor. The floor is yours.


Prof. J.W. Verret:  Thank you so much for having me and to The Federalist Society for these terrific teleforums. I’ve learned so much listening in on a variety of issues. And I’ve listened to both lectures, which will be the content today, and to debates. I’m looking forward to questions from the audience. I hope that folks are listening now. Think up good questions and in about 20 to 25 minutes, when I’m done with the basic introduction of the rule, we’ll open it up to questions and discussions from — to questions from the audience and I’ll provide my thoughts in response.


We’re here today to discuss a new rule proposal that has been put out by the Department of Labor’s Employment and Income Security administration. This rule relates to ERISA. This is a set of rules that are designed to regulate retirement funds. And the rule specifically — I’ll begin with a description of what this new proposal does to an existing area of the law that is a fairly sizable area of retirement law and ERISA practice. I’ll start with a brief description of what this new rule does and what it requires. Then I’ll rewind all the way back to the 1970’s. We’ll put on our bell bottoms, listen to a little bit of Parliamentary-Funkadelic music, maybe if we can add to the recording in post-editing, and we’ll talk about the initial purpose behind ERISA law to protect the security of American’s retirement savings. And also, in part, to ensure private pensions via related change in the law.


So we’ll go back to the original purpose of ERISA. And then we’ll walk through, in a little more depth, and add to the summary that I provide in the opening to tell you a little bit about why this rule is adopted, what it does, and I’ll also provide some of my own comments about the rule in a comment letter I just put in today for this particular rule.


So the basics. This rule relates to a type of investing philosophy that goes by the moniker ESG, or Environmental and Social Governance. It has also been called a number of other thing in the last 25 years since it has sprung up. It has been called Sustainable Impact Investment. It has been called Socially Responsible Investing. It is a philosophy about investing that its supporters say is a more holistic approach to investing. And it’s something that individual investors are free to pursue on their own.


The question becomes, first are investors getting adequate disclosure about ESG funds? And secondly, to the extent you have an investing dynamic like what you see under ERISA funds where a company sponsors retirement products particularly defined, these days, primarily defined contribution products where, in an automatically enrolled system for most investors, you essentially are automatically enrolled as a beneficiary unless you decide to opt out. And the money set aside for you, a certain percentage of your paycheck, the default is usually something like three to six percent—it could go higher if you choose—it’s put into default funds unless you choose a specific fund. And this particular rule relates to the obligations and requirements that an ERISA fiduciary, an administrator who’s running these funds and providing the menu of funds, is required to undergo in when ESG focused investments are included in ERISA savings vehicles.


So to tell you specifically what the rule does. This follows up on, in May, the Department of Labor’s New York Regional Office sent a few letters to several ERISA plan sponsors and investment consultants asking for more information about ESG investments and decision making. So this follows on, DOL investigated and compliance activity in this space. Other DOL offices have also opened investigations, similar investigations, as well. And concurrently, at this time, the SEC, the Securities and Exchange Commission, has been working with a link to ESG investing insofar as the SEC regulates disclosure about ESG investment practices and whether or not funds are adequately disclosing to investors how they rate ESG, and how ESG priorities relate to investor returns, whether there is something consistent with investor returns and superior investment returns, which is what some supporters of the ESG suggest and argue. Or whether the ESG focus its design is an exception to focusing solely on investor returns.


That goes into a fundamental question about ESG. What is it? What is it exactly? And one of the frustrating things, as you research in this area, is that it’s a very nebulous definition, to be very frank. And I think that goes to part of the reason why the Department of Labor is issuing this particular rule. Is ESG something that’s just another way to model future returns? Put it into the type of Excel spreadsheet an investment analyst would put together and prove empirically that ESG, that companies that are highly rated in terms of their environmental and social governance, however you define that rating metric – prove that they have superior returns and then model that into a spreadsheet and show that you’re making a good investment decision, in terms of the stewardship of retirement savings that you’re charged with overseeing as an ERISA plan fiduciary. Well that’s not anything new. That fits into the existing dynamic and we don’t need — I mean, it’s a new thing to model. A new potential risk factor to model. A new potential reward factor to model. But it is not really anything new or inconsistent with the existing philosophy.


So it fits very well into existing ERISA law. And [inaudible 00:07:30] what this new proposal does, is it simply fits that idea into existing ERISA law. But if you wanted to find the ESG goes is something larger than that, as a holistic view that, you know what, it’s not all about making money. We should focus our investments on helping the world more broadly. Even if it means that there is a tradeoff between those two positions. If it is that, instead, that’s a very different thing all together. And that is something that, though you are free, voluntarily, to do so as an individual investor, it is not something — not a decision that ERISA plan fiduciaries are committed to make because the existing ERISA law is pretty clear, you got to be focused on the security of those retirement savings.


So to go specifically to what this rule does. What is new here? First of all, the proposed rule has language confirming that an ERISA fiduciary’s duties of prudence and loyalty are satisfied when the fiduciary has “selected investments and/or investment courses of action based solely on their pecuniary factors, and not on the basis of any non-pecuniary factor.” That’s it. Focus your retirement savings stewardship for these ERISA beneficiaries that you are charged with protecting. Focus on that stewardship on the monetary value of investment. You’re not allowed to take into account non-pecuniary factors that are not related to superior investment returns.


The rule further goes on to say it will amend the existing regulation to provide that fiduciaries must compare investments to other available investments based solely on economic factors. If you’re comparing two different investments that you may put the ERISA fiduciary money into, you have to compare them on the basis of economic factors. It’s a reminder. You’re not allowed to include non-monetary factors. It says that, look, if you want to put money into a fund that says it is an ESG focused investment, that’s fine. But you have to demonstrate that you have an investment thesis here for that investment. As you offer that ESG-focused fund in the ERISA menu of options or in the ERISA default money, for those investors and beneficiaries that are not actively choosing their investments, you have to have a thesis, an investment thesis that this is going to lead to superior returns.


And, here’s what’s new with this rule, you have to document that fact as an ERISA fiduciary. When DOL comes by for a compliance inspection and audit, and you say, oh yeah we have this menu of ESG-related investments. And DOL asks the question, as they have been asking when they audit, particularly out of the New York office, what do you base that on? I think probably right now, how that conversation went in May was, we based that on our professional opinion. That’s not enough. And this rule is going to make clear that when you’re asked that question, you have to say, well look. Here’s how we can prove that we have a reasonable basis to assume that this investment is going to — this ESG particular investment, is going to have superior returns for the beneficiary. That’s going to help that fiduciary to better protect the retirement savings of that individual beneficiary in a way that is consistent with the design function and original legislative intent of ERISA law.


One subcomponent of this is that the proposed rule that says that where two different investments seem to be economically indistinguishable and you’re looking for sort of a tie breaker, is how this is described. An all-things-being-equal test. Fiduciaries have to document why the investment was indistinguishable and why the particular investment is chosen. So DOL retained the all-things-being-equal test. So you can pick an ESG over a non-ESG investment as long as they are equal risk, reward, return, liquidity, the basic factors you might think about in a purely monetary focus investment philosophy. But you’re going to have some rigor behind that decision that you’ve got to document.


The proposed rule adds a couple of requirements. One of them is particular and unique to a type of fund called a Qualified Default Investment Alternative.  A QDIA. What is a QDIA and why does it matter? Well, basically, in ERISA law, if you take client money and you put it into investment, there are two ways this happens. Either, as is the case with most retirement funds, it’s an automatic contribution. The beneficiary does not affirmatively object. But it is by default put into an investment.


On the other hand, it could happen that the individual beneficiaries are more active when they get that initial employment paperwork. When we say, you know what, I want to choose a specific product. Well prior law, before the creation of QDIA, prior law said that if the beneficiary makes the choices, then the plan administrator has an exemption from liability because they’re not the ones making the choices. Well, QDIA was added as the world moved toward more automatic enrollment. The idea of a QDIA was added, which is to say, a type of investment that’s fairly safe, fairly popular.


Think of it, for example, a QDIA is basically something that has to be very well diversified, not too risky. It’s essentially like the kinds of end-year funds you might get that you might understand on a retail basis from Fidelity or Vanguard or one of those, or basic index funds. Something that is diversified into both stocks and bonds, both equity investments, and fixed income investments. And the reason why I give you all that background on the QDIA is, is that — so a QDIA, once defined as a QDIA, if you put that automatic money, and the beneficiary doesn’t get involved in making decisions about each, with QDIA, you can get the same opt-out from liability as a plan administrator that you would get from if the beneficiary made their own decisions.


In any event, all of that background is to say that this rule proposal says that ESG investments are not appropriate for inclusion in QDIA because of that special liability exemption that comes along with QDIA investments for the automatic enrollment type funds. This is in line with prior restrictions with QDIA. One of the other things they said was that QDIA investments can and must invest in the firm. If Zero Electric is running the QDIA, QDIA can’t invest back in General Electric. That would be a conflict of interest and so you want to limit that potential conflict of interest. That’s along the lines — along the same lines as the conflict of interest motivating concern that is at play here.


So in any event, to provide a little bit more background and kind of drill down on the rise of ESG and essentially changes in ERISA regulation over the years, let me — that’s the 15-minute version. Let me just provide five or ten minutes of additional background and particular perspective that I have on the proposal and then we’ll open it up to questions because I know a Thursday afternoon lecture, an hour-long lecture, is not what you want.


So to go back all the way to the beginning, go back to the 1970s. I’m technically a child of the ’70s because I was born near the tail end of the ’70s. But unfortunately, I didn’t get to experience most of the 1970s. The Employee Retirement Income Security Act of 1974 was something adopted, in part, in response to a crisis, a pension crisis going on at the time, a number of pension issues happening in the news where, essentially, what would happen in the worst scenarios, employees would be brought into a company with the promise of a pension. And one of two things would happen. Either the company would be sold off and the pension would be raided, or there would be a crisis at the company, a bankruptcy at the company, and come to find out, the pension was not well funded.


They were all defined benefit plans, something that’s still popular in some government positions, but it’s almost been wiped out in private sector funding. It’s all defined contribution, where you give a certain amount and you get the returns. This was defined a benefit. You have a fixed pot of money every month, or quarter, whatever. So defined benefit plans were often in trouble. And sometimes, what would happen, in order for a company to try to maintain the health of a pension, what they would do was they would have very strict rules about the pension. So that, say for example, there might be a vesting requirement of 30 years. Either you work for 30 years, or you get nothing. And an employee might come in, might retire at 30 years and say, okay, I want my pension. And they would say, oh, remember back at year 26 when you took a month off for medical leave because you were in an accident. I’m sorry, but the rules are clear, 30 years. 30 years mean 30 years. And it’s uninterrupted 30 years. So if you leave for a month for a health problem, the 30-year clock actually starts all over again.


That was another issue. And this all built up into a story about the bankruptcy that followed Studebaker Company, where so many of the beneficiaries of that defined pension plan were left with nothing. That led to a special, to a TV special that was widely viewed and that led, ultimately, to Congress’s passage of ERISA.


So ERISA is a stewardship law, essentially. It says, look, if you’re going to run retirement money for someone else, you are a steward. And it uses language from trustee law in the common law. You’re a steward of that money. You are a fiduciary, which is the strongest obligation in the common law. You are a fiduciary for that money. You have a single duty of loyalty and care. And that duty of loyalty and care is further defined as what a prudent investor would do in the course of their investments. And that has been defined over the entire course of ERISA law as a shareholder wealth maximization. And also, informed by the idea of reward/risk tradeoffs, it further evolved into an embraced portfolio theory, the idea that all else equal, sometimes keep the same returns but with less risk, and therefore get higher expected returns while investing in a portfolio of securities that do not all go up and down in value at the same time. So it embraces a portfolio approach, it has a singular focus on the fiduciary obligation defined as the prudent investor standard.


Fast forward to 1994, under Labor Department Secretary Robert Reich, begins this idea of incorporating what was then sustainable impact investing, what has gotten the new moniker, ESG investing. In 1994, the Reich Department of Labor issued some guidance that says, essentially, as long as you can incorporate it into an economic calculous, you’re allowed to consider, in part, ESG — what’s now defined as ESG factors. So it’s a small step toward including ESG in these determinations. But the guidance from the Reich DOL was not any kind of an allowance to set aside shareholder wealth maximization into the sole deciding factor here. And I mean that defined, it’s not the investment with the highest return, but also relative to risk involved, relative to also liquidity in this particular investment. But generally, monetary [inaudible 00:20:33]. So it allowed the inclusion of ESG factors, which this rule would also do. I would say, this rule is completely consistent, I will argue, with the original consideration of these factors in DOL guidance under the Clinton administration and when Robert Reich was secretary.


So that has led to, essentially, a sort of an oscillation of guidance from, then the Bush administration, and then the Obama administration. So two additional pieces of guidance that’ve come along. There were [inaudible 00:21:08], they were not. They were adjustments at the margin, a little bit. The Bush administration raised the bar for what you have to show if you’re going to consider ESG factors and essentially made it a pure value proposition. The Obama administration pulled it back in the other direction.


And I think this is an attempt, this rule is an attempt to just codify this discussion. And again, put into a rule, a formal rule rather than guidance, the same approach that was taken by the Clinton administration, it adds to what the Clinton administration said. It adds to that some due diligence requirements. It adds to that some requirements about maintaining documentation about your decision making process. And it adds to that, the additional point, that with respect to QDIAs, they are not allowed to include ESG factors.


So one of the important things to keep in mind here is that this maintains a role for ESG. You can provide ESG investments. You can provide that option. For those investors that are actively involved in making decisions about their portfolio, they can pick from, they can select from any ESG focused funds if they choose to do so. There has to be documentation that those options were selected in accordance with the basic statutory language of ERISA. And that’s it.


That’s essentially what the rule does. Now this has been controversial. I think I’ve fairly described this rule and what it does in probably mind-numbing depth for some folks that are not experienced in ERISA issues. But that’s what it does. Nevertheless, a couple senators, Senator Berkley has sent a letter asking for this to be abolished. That the rule be stopped. So it has a political character to it.


The only thing that I want to add that, just to talk about if I can indulge myself and talk about the comment letter I submitted to the Department of Labor in support of their rule making, because personally, I do support this particular rule. I think it’s measured and considered. I offered a couple different perspectives. In particular, I wanted to highlight a survey that I did in conjunction with a survey firm called Spectrum. And I conducted a survey for — I provided this survey to the SEC, with respect to a similar related issue that they were considering in the rule making. And a number of questions in the survey were unrelated, they were about a different corporate governance matter. But one of the questions that was contained in the survey was a question about ESG. It was a question about ESG investing. And what I asked the survey respondents, and these were 5,000 investors. So we have some incredible statistical power behind this survey. This is a bigger survey than any political poll will ever see. It’s 10 times larger than most of the political polls you’re going to see.


We surveyed 5,000 retail investors, 67 percent of which were participants in defined contribution plans. And we asked them, just a basic question here, on a scale 1 to 100, 1 being pure ESG, 100 being pure shareholder wealth maximization, what is your goal out of your retirement savings? What do you want? The median score we got back was a 76 on a scale of 1 to 100. A 76. So fully 75 percent of the way for shareholder wealth maximization, strongly in the other direction. If you speak about the tail end here, 17 percent of respondents were totally [inaudible 00:25:05] shareholder wealth return maximization. In other words, 17 percent of those respondents picked the number 100.  Only .02 percent of them picked the number one, that they were purely political social objectives. And 91 percent of people responding, this is the key takeaway her, 91 percent of those 5,000 investors indicated a preference of wealth maximization over political and social objectives.


So I offer that point to suggest that ERISA and ERISA’s statutory focus, the legislative intent behind ERISA, of a pure wealth standard for insuring the prudent care of retirement savings is a standard that, despite being now 45 years old, is a standard — 46 years old, is a standard that still reflects the preferences, the overwhelming preferences of ERISA beneficiaries. So I’m a big believer in ERISA. I think it’s protected our grandparents and our parents in their retirements. And I think that this rule is a minor codification of guidance going back to the Clinton administration, consistent with guidance from the Clinton administration. It’s a minor step and I hope that survey is helpful to the Department in their consideration of the final proposal.


That’s all I have for now. I’d love to get questions, thoughts, feedback, pushback, whatever.


Nick Marr:  All right great. Let’s go to audience questions now. And just to start us off, Professor, to give callers a chance to line up in the queue, I’ll just ask could you briefly go over the opposing arguments?


Prof. J.W. Verret:  Yeah, so the — I haven’t read all the comment letters but I think that supporters of ESG are concerned that this particular proposal will discourage the use of ESG-focused investments. To which I would say, first of all, I think the ESG community needs to better define their terms. What exactly do they mean? And now just in narrative format. But if we’re going to be talking about investment advice, you need to show me some Excel spreadsheets. You need to show me some discounted cashflow models for how ESG focus investments can have superior returns for investors.


If we can get to that kind of discussion, I think we can have more nuanced and focused discussion about the role of ESG investments. And some people are doing that. And there is some economic evidence to suggest that this can be valuable. But that’s not the overwhelming result. I think the literature’s, at best, mixed. And particularly, I would point to a piece in the Review of Financial Economics by Halbritter and Dorfleigner that does a survey of ESG investing evidence going back quite a ways. And they say, “ESG portfolios do not state a significant return difference between companies with high and low ESG ratings. Magnitude and direction are substantially dependent on the rating provider, the company sample and the particular subperiod. [And ultimately,] investors should no longer expect abnormal returns by trading a difference portfolio of high and low rated firms with regard to ESG [prospects].” Review of Financial Studies is the leader in the finance literature. That is — I think that study is as of 2015 or 2016.


So that, to me, you can do an ESG portfolio, but you’re need to have some kind of documentation on why that overall survey of the literature does not apply with respect to your particular investment, I think, to make it past a DOL compliance inspection for whether or not you’re complying with this rule.


Nick Marr:  Thanks very much. We’ll go to our first audience question. We have quite a few lined up here.


Caller 1:  Hi. And thanks for that very informative presentation. Two-part question. First, what do you make of the recent SEC comments and another analysis that seek to take apart the ES and the G and attribute a lot of the value creations and following such a strategy to the G letter, the governance practices, and that the E and the S maybe mutual, even drags. What do you make of those comments and analysis that have come out?


And the second question would be this. Assuming the rule goes in and you were an in-house lawyer advising a plan sponsor who came to you and said, you know I really want to look into this. What kind of documentation and analysis am I going to have to put together? What should it look like? What are the things that it should consider in order to defend my decision if I want to offer an ESG type in my plan?


Prof. J.W. Verret:  Well, thanks for those great questions. I can speak more to the first than the second, but I’ll take a crack at number two. It sounds like that might be what you do. I’d love for you to jump back in the queue and tell me what you think would be a good idea, some good ideas for compliance best practices.


The first point, and Chairman Clayton at the SEC has often said this when he talks about ESG issues, that we need to separate out the E, the S, and the G. As someone who’s done a lot of work on the empirical side of corporate governance, I have a lot of respect for the very G focused part of this. I’m actually mixed here, in terms of discussions about ESG.


The G, I think, is much easier to show a length of premium returns in governance. Not always for if the proposition is, should we have a rule about a particular governance item that applies to all firms all the time. It’s sometimes hard to make that empirical case. But for some specific firms and some specific areas or types of firms, there are various governance issues that can be very salient from an empirical perspective. And that you can match, for example, a particular governance attribute to abnormal shareholder returns over a timeframe, or that you can match to things like financial transparency.


Oftentimes, in the accounting literature, it means the level of discretionary amortizations contained in the financial statements. That’s sort of a rough proxy for how solid your accounting is. More discretionary amortization’s a problem that, not always but more likely than not, a problem with that. And there’s some good literature on that. And so I’m sympathetic to some G issues. And there’ve been a lot of activist hedge funds that have made a lot of money for people focusing on reforms in the G space. So I share the view that the E, the S, and the G need to be separated.


Some of the proponents of the E and the S urge that this is a moral issue and we need to have a bigger focus. Some of those issues, though, by the way — I mean this is more of a social debate, but some decisions are better left to legislative and regulatory issues. I think it’s probably better to do environment enforcement out of the EPA rather than at a shareholder’s meeting where nobody at that shareholder’s meeting is equipped to do environmental enforcement.


In any event, there’s some effort to model issue with respect to the E.  There are some issues where that’s very sound, with respect to measuring the cost of environmental fines, for example. That’s very basic. But that’s not really even needed. That’s something already incorporated in regulatory risk, or litigation risk in existing financial models long before ESG.  So it’s something that fits there, as well, but this is not new from my perspective.


With respect to best practices on compliance issues. You know, I would say look to — you’re going to have to make a choice about a ratings — an ESG ratings provider and that you trust and you like. But they’re all very new. They’re all competing. They all have some nuanced difference. There’s a lot of subjectivity in them. I think that the folks at the Sustainability Accounting Standards Board are trying their best. They’re not FASB. No offense. They’re not Financial Accounting Standards Board. They don’t have the rigor. They don’t have the depth of process. But they’re doing their best and I think they’re making a legitimate effort. So check out what SASB has. It’s not to say I always agree with them. They’re a voluntary organization for ESG certification. I think that that’s probably the best group out there right now.


Some of the insurance companies are doing interesting things. And you can check out the credit rating agencies too. I think check out the ESG work that S&P is doing. They’ve got issue rating stuff and I think S&P has every incentive to play it straight with respect to this stuff and shareholder values. They’ve probably got some tools — they are the requiring [inaudible 00:34:36] probably have some tools you can use there. I’d probably start there. But leave it to practicing labor lawyers to really give you some good advice. I can’t give you legal advice. I’m just a law professor. But if you want to jump back in the queue, I’d love to hear what you think.


Nick Marr:  We’ll go to our next question now.


Caller 2:  Hi Professor. I was wondering  how this would affect state laws that prohibit like public employee pension funds from investing in places, whether it’s in Iran or maybe investing in companies that are part of the BDS Movement or things like that, how the rule would affect state laws or policies like that?


Prof. J.W. Verret:  Yeah, I don’t think it would have much effect, unless for some reason, state judges look to ERISA guidance in some way to help them just because they think their statute might have been written, inspired by ERISA. You might get some of that in a little bit in trying to interpret state statutes. But not much. I think those kind of stand on their own.


And there are the analogous statutes. For example, there’s a statute that governs CalPERS and the other big pension funds in California. And there’s been litigation on issues like this. Is CalPERS political issues that don’t help to shareholder returns? There’s also in a state-based case in Virginia against the Virginia pension system and was successful for the claim that those running the pension were distracted and more focused on [inaudible 0:36:14] sized goals with the pension. But not a lot of impact, I would say, at the state level.


Nick Marr:  We’ll go to our next question now.


Caller 3:  Hi Professor, thank you for taking the time this afternoon. Quick question. I’ve done a little bit of background reading — or excuse me, writing on the ratings agencies that you talked about and S&C Global being one of them. One of the concerns that we had in looking into this was that the ratings were all over the board. Different companies could be rated completely differently by different ratings agency. And one thing, in talking to some of them and others, that we quickly figured out was that there needs to be some kind of universal, we’ll call it, definition of what the E and the S and the G actually mean.


My question is, do you see that actually occurring. For instance, you mentioned S&P Global. I know that in their assessment of ESG, they use a materiality standard to determine whether it is, in fact, going to be something that they will consider in their ratings. Do you foresee something like that happening? I know the SEC has their purse in particular who’s looking at it. Do you foresee that coming out of the DOL? Or do you think DOL is going to defer back to the SEC? Or what are your thoughts on that?


Prof. J.W. Verret:  The DOL regulations are not going to be as focused on the concept of materiality just because that’s primarily a disclosure based concept at the SEC. I guess that would come into play in the event there were — you know you would limit compliance or fiduciary litigation if the factions are non-material. But the definition here of when compliance [inaudible 00:38:07] are triggered and what’s not allowed to be in the QDIA is just, is it an ESG focused investment? That’s it. I don’t know if — maybe it’s only a question for the final rule. That that might have to be tangled out in the final rule, how you define what is and is not a partially ESG-focused investment. It’s just a little part of what’s going on. I don’t know how that will ultimately shake out. I don’t think it is completely [inaudible 00:38:34] from the proposal. But it could potentially be better laid out, I think, in the final rule.


Incidentally, folks should comment. There’s a short comment period at the end of the month, the comment period closes. But I think it would be helpful to the Department in consideration of this issue.


Nick Marr:  Go to the next question here.


Peter Flaherty:  Hi Professor, this is Peter Flaherty, National Legal and Policy Center. The question was asked how critics are characterizing the rule, and I believe some of them would call it an obvious attempt by the Trump administration to protect big oil companies and discriminate against minorities and to hurt women. That’s kind of a hard thing to go up against. I would suggest that, in addition to the very good arguments that you’ve made today, that the issue be recast in terms of shareholder rights. In theory, the beauty of markets is that if you don’t like a stock, you can just sell it. But most people don’t have that option. They own stocks through retirement funds and mutual funds.


And so when Larry Fink threatens a couple hundred companies, he’s not using his money, he’s using other people’s money. And Fink’s views may clash with the people who invest in his funds and they have very little recourse to do anything about it. I suppose they could sell their BlackRock funds, but most people really don’t have that option. So I would suggest that this be recast in more populous terms. That the corrupt one percent, like Larry Fink, are using the money of working people to promote their corrupt values. And it’s unjust. What do you think?


Prof. J.W. Verret:  I think you would really like, there’s a particular phrase in the proposed rule that I’ll probably paraphrase it. I won’t quote it exactly. I don’t remember it exactly. But it says, while we’re talking about ESG, Environment Social Governance, there is no more important social issue than the protection of people’s retirement savings. And I think that’s a great way to kind of — it’s buried in the proposal. I would make it the first line as their final rule. Because I think it is important. It is incredibly important to everyone.


Peter Flaherty:  Okay, but that’s the economic argument. I’m talking about a moral argument. I’m talking about people who hold these funds and the management of these funds is — are involved in a whole host of causes that may be contrary to the moral beliefs of the people who are their customers.


Prof. J.W. Verret:  Yeah, well you should check out — I have an article in National Review from last week about BlackRock.


Peter Flaherty:  I have it right here.


Prof. J.W. Verret:  Oh great, there you go. I got a reader. Thanks. Thanks for checking it out. So I agree, and one of the things I said in that article, for the benefit of everybody else, is that I thought that there was uniquely there a conflict of interest and a potential fiduciary duty violation in that if the company BlackRock and its international shareholders decides to take up a new policy for its investments, they might be violating their fiduciary duty to the beneficiaries of the mutual fund that they run, which are different investors than the investors in BlackRock parent. To the extent you appease a minority of investors in BlackRock parent, you might actually be violating your fiduciary duties to BlackRock Mutual Fund beneficiary. That’s a SEC specific issue, but I think it’s related.


Peter Flaherty:  Thank you.


Nick Marr:  Next caller has the floor, area code 470.


Caller 4:  Good afternoon. Thank you for your remarks. You touched on this a little bit with respect to governance. But is management an economic issue, a monetary issue, or is it in the non-monetary witchcraft consideration?


Prof. J.W. Verret:  I would argue that the governance issues, you could more directly make — I think it would be easier, to the extent you want to look at the governance part of ESG, the corporate governance [inaudible 00:43:06]. It’ll be easier to make the case that those are pecuniary issues. I think that’ll be a lot easier.


Caller 4:  So you think that a particular management’s operation of a business is a plus factor or a minus factor?


Prof. J.W. Verret:  Yeah, I think so. And I think you can say that pure pecuniary. Frankly, I don’t think that’s even really an ESG focus. You know, I think that’s just a traditional financial focus.


Caller 4:  Right. That was more to the fiduciary obligations and just what was in the scope of the legitimate considerations. So thank you.


Nick Marr:  We have one more question lined up.


Caller 5:  Hi, yes, hello. An observation, I wonder if you would share your thoughts on it. It’s inspired by an earlier caller’s question. You posited and so, in some ways, has the Department of Labor, that the loadstar here is risk adjusted investment returns for the plan participants and beneficiaries. And it strikes me that when it comes, especially to the E and the S factors, those are inevitably value driven and there’s really no way short of making normative points about what you think justice or morality is to set reliable standards on that. Someone may say investing in industry X is contrary to E and S. Someone else might say no, it’s the opposite. Investing is consistent, in fact to be encouraged, for good E and S.


And unless you’re looking at returns, something measurable returns for the exclusive best interest of the plan beneficiaries, I don’t know that there’s any objective third-party standard that really is going to help. Because there is no such thing as an objective third-party standard. It’s all values and morals and there’s nothing wrong with that when you’re investing your own money. But when you have a fiduciary duty to somebody else, that’s not what you should be looking at, is your own moral or philosophical judgment about what is justice.


I wonder how that rings to you and what challenge that might be if this goes forward to establishing a good basis, other than strictly, run it through the spreadsheet, this produces historically as good a return or better than another alternative.


Prof. J.W. Verret:  Yeah, it doesn’t have to necessarily be better, just has to be as good as to be real specific about the rule, the tie breaker aspect. I largely agree with what you’re saying, I think that’s consistent with the spirit of this rule. I think that there are some folks who promote ESG investment as a way to generate superior returns who, if they can prove it, should be perfectly fine with this rule. This rule’s not going to hurt their lives. For those folks who are looking to sort of sneak this in to the retirement savings of folks who don’t want — who don’t share the priorities, they might have concerns and that might motivate some of the political pushback here. But I hope as I’ve honestly laid out, this rule is just bread and butter ERISA fiduciary requirements to protect the time and security of it.


Do we have any more questions or should I wrap it up?


Nick Marr:  We don’t have any more questions so I’ll offer you a chance for any closing remarks you might want to give before we wrap up today.


Prof. J.W. Verret:  Yeah, thanks to everybody for joining the call. It’s always fun to do FedSoc panels and talk and talk to some of the leading lawyers from all around the country. So this has been terrific. I’ve learned a lot. Again, as you said in the intro, I teach at George Mason Law School, at Scalia Law School and I also run Veritas Financial Analytics, corporate governance and accounting. I’m also a CPA, accounting consultant firm. So if you want to have some more discussions, I’m always just a short email or phone call away. Thanks to everybody and thanks FedSoc.


Nick Marr:  Great. And on behalf of The Federalist Society, I want to thank you, Professor, for the benefit of your valuable time and expertise today. And to the audience, thanks for calling in today. We welcome your feedback by email at [email protected]. Keep an eye on your emails and on the FedSoc website for upcoming teleforum calls. Thank you all for joining us today. We are adjourned.

J.W. Verret

Associate Professor of Law

Antonin Scalia Law School

Financial Services & Corporate Governance

Federalist Society’s Labor & Employment Law Practice Group

The Federalist Society and Regulatory Transparency Project take no position on particular legal or public policy matters. All expressions of opinion are those of the speaker(s). To join the debate, please email us at [email protected].

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