THE TRUMP DOL’s REVILED ESG RULE MAY HAVE SAVED THE IMPACT INVESTING INDUSTRY

By Alexander Golding, Skytop Contributing Author July 1, 2021

Alexander’s educational career started at NYU’s Stern School of Business, where he earned his baccalaureate degree in Finance. While at Stern, Alexander specialized in entrepreneurship, starting a cannabis business that did $3 million in sales. He took this knowledge on entrepreneurship to Florida Atlantic University, where he taught “Topics in Social Entrepreneurship” in the fall of 2017, where he taught undergraduate students how to prepare a business plan for a social enterprise. 

Professionally, Alexander is the founder and CEO of Helped Hope LLC, a conference
production firm that specializes in impact investing for institutional investors. As a convenor, he attracted over $100 billion in AUM to the ‘Transformation2030’ event series held in New York City and San Francisco. Helped Hope LLC also boasts a well-managed contact list of over 7,000 members, from corporate sponsors, to speakers, and audience members. Tech industry standouts such as Andrew Yang, Brittany Kaiser, and Adam Draper all keynoted at his events.

Following ‘Transformation2030’s success, Alexander originated, analyzed, and advised on over 400 direct and fund investments, accepting only 3% of proposals. After presenting in front of several different institutional CIO’s, he executed on 7 deals, totaling $2,875,000, one of which will IPO in 2021. 

Currently, Alexander is working on his Masters of Business Administration from The George Washington University School of Business, where he was awarded the Marvin L. Kay Fellowship in Finance.

___________________________________________________________________________________

Executive Summary:

On June 30, 2020, the Department of Labor published a draft ruling aimed at ending the growth of the impact investing industry in the $20 trillion Employee Retirement Income Security Act of 1974 (ERISA) investment management market. Industry pushed back, resulting in the removal of almost all language directly targeting the socially responsible investing (SRI) and environmental, social, and governance (ESG) factor investing sectors from the final ruling, which came out on November 13, 2020. As a result, the ‘Final Rule’ mostly reiterated the Department’s long-held view that plan fiduciaries focus solely on “financial rather than nonpecuniary benefits” (Labor, 2020) when doing investment analysis. 

Scarred by the draft rule, the industry viewed the Final Rule as a thinly veiled threat and opponents began strategizing nonmarket solutions to the issue. Their prayers were partially answered, in that a week after it went into effect, newly elected President Biden issued a directive that the DOL should review the regulation. Two months later, the Department issued a non-enforcement letter, removing the immediate anxiety from the impact investing world.

Yet, despite this turn of events, the regulation may still splinter the impact investing industry. Plan fiduciaries are now highly aware of the whipsaw nature of regulation in this sector and may find themselves remaining clear of SRI financial products in order to be less liable for legal troubles. They may feel the same way about ESG strategies, though this is less likely due to the wording of the rule. As such, the SRI industry may find itself at odds with its ESG colleagues and associates, and it may have to change its strategic positioning to reflect this new reality. 

As a result, this rule may give ESG its moment in the sun. It was often held back by the conflation of SRI strategy returns (often seen as subpar) with its own. If ESG strategies gain an advantage because of the rule, then they should take it and show the world that they can produce top returns.

Of course, opponents of the rule will employ nonmarket strategies to try to change the regulations to be in their favor, or to mollify the rules’ impact. Washington, D.C. insiders have confidentially mentioned that members of Congress are drafting legislation that would override the DOL’s rule. There are also rumors that regulators are being pressured to draft a new rule invalidating the November one. 

Regardless of what happens, ESG product sponsors should capitalize on this moment and use it to their advantage. They may never have as opportune a time as this.

On November 13, 2020, practitioners in the burgeoning sector of financial services known as socially responsible investing (SRI), environmental, social, and governance (ESG) investing, and impact investing were dismayed when the Department of Labor (DOL) amended the Investment Duties DOL Regulation §2550.404a-1. This Final Rule refined the parameters that fiduciaries managing the $20 trillion in US assets that fall under the purview of the Employee Retirement Income Security Act of 1974 (ERISA) must follow when making investment decisions. It mandated that fiduciaries make investment decisions based solely upon “financial rather than nonpecuniary benefits,” with particular attention paid to the default investment strategy in a 401(k), known as a Qualified Default Investment Alternative (QDIA). The Final Rule also emphasized the long-held view that plan administrators must focus on minimizing plan expenses. This regulation, by the Department of Labor’s own admission, was targeted at limiting the growth of the impact investing industry. 

Investor dismay, however, is premature. The DOL stated in the rule itself that “E, S, and G factors can be both pecuniary and non-pecuniary in nature,” permitting ESG investing. Furthermore, one of President Biden’s first actions as President was to order this regulation’s review by the Department of Labor. In response, the DOL issued a non-enforcement letter in March of 2021, signaling to the retirement plan and financial services industry that both SRI and ESG investing remain allowable. In other words, there is significant opportunity for the sector to grow within the bounds of the regulation, and opponents to the rule still can engage in nonmarket actions to try to get a new regulation passed that will overturn the November one. 

Despite the non-enforcement letter, significant pressure exists for plan fiduciaries to primarily concern themselves with the analysis of pecuniary matters, along with regulatory uncertainty around the ability of SRI practitioners to steward ERISA retirement plans. The crux of SRI investing is incorporating nonpecuniary factors based on a person’s or firm’s political or moral values into an investment analysis. For this reason, plan managers may eschew SRI financial products going forward, and may favor ESG managers or traditional financial managers over them. 

Even so, there is some hope the Final Rule will benefit the broad impact investing industry through facilitating the process in which capital is allocated to the most efficient ESG investment strategies. Such direction may force practitioner decisions to create and manage either SRI financial products or ESG ones, a sorely needed clarification as the distinction between the two styles is often not made or is conflated in investment product formulation. Doing this would rehabilitate the sector’s image of earning subpar returns (SRI products are viewed as having worse returns than ESG ones). Further, if plan fiduciaries do prevent socially responsible investing products from being included in retirement plans, this may protect ERISA plan administrators from violating Title 1 of the Employee Retirement Income Security Act of 1974 (ERISA) by preventing the abuse of power to further personal or nonpecuniary goals. For instance, it has been posited that, were they allowed, plan administrators might provide revenue to special interest groups by investing in private equity style projects that hire these groups but are forecasted to produce below-market returns. This issue prompted several letters to the DOL asking its prevention. For instance, the 2020 Chair of the West Virginia House of Delegates Pensions and Retirement Committee, Dianna Graves, wrote the DOL asking that the agency ensure retirement plan money not be used to further plan fiduciaries’ political goals. 

As with every debate, there are both supporters and opponents to the Final Rule, and undoubtedly each faction is strategizing their next move. Indeed, recent personal interviews with Washington, D.C. insiders revealed that opponents are advising members of Congress on draft legislation to override the regulation; and further, the Administration purportedly seeks a new regulation that will supersede the November Rule. 

The biggest opponents to it are SRI practitioners. They point out that the Final Rule is just one more iteration of decades of sub-regulations put out by the DOL, sub-regulations which often reflected the political leanings of the ruling political party at the time. However, they claim that, under the Trump Administration, the government’s action was unique in that the DOL issued a formal ruling, something which takes significant political capital and a long time to undo. It also seemed motivated to hurt the SRI and ESG industry. As mentioned earlier, the DOL even admitted that blocking the consideration of nonpecuniary factors from investment analysis would hurt the sector. Therefore, it is imperative that an investment manager demonstrate to plan fiduciaries that he or she did not consider nonpecuniary factors during the investment analysis process so that his or her strategy can be used in a QDIA plan. If they were considered but did not drive the decision, then that strategy can be used in non-QDIA ERISA type plans. 

As of now, proponents of the Final Rule remain unclear about the Rule’s impact, because Biden’s actions effectively put the bill in limbo about a week after it went into effect. Members of industries targeted by the SRI community (such as the fossil fuel, defense, gaming, tobacco, and alcohol industries) presumably would favor it, as would traditional, non-ESG investment managers, and pure-play ESG managers.

The pathway the regulation created for the ESG industry is very clear: investments should produce market rate returns and analysis should focus on factors that are material to the risk and/or return of the investment considering its time horizon. The need for regulatory oversight comes from the “alphabet soup” of terms, definitions, and standards in the broader impact investing industry, of which both SRI and ESG are components. Since the industry has its roots in socially responsible investing, outsiders often conflate the two different analysis frameworks and assume that ESG funds incorporate SRI values. This is not the case. 

Another complicating issue stems from poor governance on behalf of ETF, mutual fund, or collective investment trust fund managers. The Wall Street Journal and Financial Times have repeatedly reported on conflicts between funds’ written mandates and their holdings. For instance, The Journal reported in November 2019 that Vanguard Group’s FTSE Social Index Fund held Occidental Petroleum stock (a company that in 2015 was mired in controversy that it may have polluted the Amazon), despite having an investment mandate that banned the fund from owning “companies with significant controversies regarding environmental pollution or severe damage to ecosystem.” In another example of industry hypocrisy, the Financial Times reported that a “third of low-carbon funds invest in oil and gas stocks.” This article exposed the ways that funds managed by blue chip names such as HSBC, Ossiam, and Lyxor invested in fossil fuel companies, contravening environmental objectives that should have prevented such investment. 

By passing the Final Rule, the Department of Labor protected pensioners’ long-term benefits by encouraging plan fiduciaries to do additional due diligence. This will prevent them from investing into greenwashed products. Thus, by ridding the industry of fraudulent offerings, the Final Rule helps the sector come of age.

The media also reports the industry lacks standardization. This is another issue that the regulation, by requiring risk/reward analysis, tries to address. ESG ratings firms notoriously assign different ratings to a company than their competitors do. For example, a company rated by Truvalue Labs may have a different rating by S&P Global which may have yet a different rating from MSCI’s Sustainalytics. Therefore, ESG portfolios put together using these ratings “yield large performance dispersion and low correlation of returns.” A less than diligent manager may not know this. By encouraging financial managers to do their own in-depth research, the regulation may spur industry-wide maturation and force ratings companies to agree to standard measurements.

Considering the sheer amount of wealth at stake in ERISA plans, these issues are timely and must be taken seriously. For this reason, many wealth management or asset management groups have created their own internal ESG due diligence teams. Neuberger Berman, for instance, hired several PhD’s to examine climate related risks, and Ares partnered with Aligned Climate Capital on its most recent energy infrastructure fund. As former senior ranking officials at the Department of Energy, the founders of Aligned brought significant experience in the renewable energy space and the sustainability risk reports that Ares and Aligned jointly produce are just as quantitatively rigorous as a traditional risk model. These two instances are not isolated examples and demonstrate what is quickly becoming the norm. In depth sustainability risk analysis should have always been a standard operating procedure for the industry, and this legislation will force it into being, at least for managers hoping to steward the $20 trillion in America’s retirement plans. 

For these reasons, the ESG community will find that this bill is in their best interest and should not fight it. Practitioners in the space with multi-year track records of strong performance, such as Bill Davis of Stance Capital or the ESG team at Royal Bank of Canada (RBC), can use this bill to their advantage and press plan fiduciaries to offer their strategies to participants. 

One cause for concern would be the Final Rule’s reiteration that fiduciaries reduce management fee expenses as much as possible. The ruling does, however, directly acknowledge that extra research incurs costs, and that time and labor spent researching and analyzing ESG factors constitute a worthwhile expense. Not only worthwhile, they will be a necessary expense if ESG product sponsors want their offering to be a QDIA, as the ruling specifically states that off the shelf sustainability ratings programs may “evaluate one or more factors that are not financially material to investments.” Therefore, they will have to hire a team and build their analysis de novo the way Neuberger Berman and the joint venture between Ares and Aligned Climate Capital do.

To justify such costs, managers need to educate plan fiduciaries on their success as well as the substantial body of evidence that shows that ESG analysis reduces risk and improves performance over the long run. The publication of this research is one major reason why so much capital has flowed into ESG-denominated funds. According to Morningstar researcher Jon Hale, not only did ESG funds outperform conventional funds in 2019 and 2020, they also outperformed when the market dropped in March 2020. In fact, Hale discovered that “24 of 26 environmental, social, and governance-tilted index funds outperformed their closest conventional counterparts” during the first quarter of 2020. In other words, they outperformed during the bull years of 2019 and 2020 and the dive in March 2020. Their success is succinctly illustrated in this figure:

This phenomenon represents a broad macro-reallocation of capital into more productive verticals such as health and wellness or tech, and away from relatively less productive uses of capital such as construction. For example, according to Tensie Whelan and Randi Kronthal-Sacco at NYU Stern’s Center for Sustainable Business, growth in the food and beverage industry is primarily driven by “sustainability-marketed products, [which were] responsible for more than half of the growth in consumer packaged goods from 2015 to 2019.” The same is true of technology stocks, most of which score well on standard ESG assessments such as the B Impact Assessment run by B Lab, one of the most respected names in the ESG assessments space. It is well known that blue chip tech names have outperformed the broader economy over the past decade without being riskier than old-world businesses. This is a key metric that spurred their dominant position in many of the market-following ETFs that comprise the majority of the investment strategies offered to retirees. 

One major repercussion of the Final Rule may involve the splintering of the impact investing industry. This industry has always been overshadowed by a group of SRI practitioners advocating for the consideration of nonpecuniary factors in investment research. Some go so far as to make investments that they know will earn relatively low rates of return and encourage others to do likewise for moral reasons. This attitude diminishes the respect of the ‘impact investing,’ ‘socially responsible investing,’ and ‘environmental, social, and governance investing’ fields. By preventing ERISA funds from being managed by SRI practitioners, the Department of Labor may have finally given ESG the room it needs to prove once and for all that considering the material effects of environmental, social, and governance factors on a business’s operations generates alpha while mitigating risk. 

The SRI and ESG communities may find themselves at odds when the opponents to the Final Rule engage in nonmarket actions to effect a permanent rule change, either through lobbying Congress or through lobbying the Administration to try to get a new regulation. As explained above, it is not in the ESG industry’s best interest to support initiatives that benefit SRI, but the industry is historically tight-knit and the fact that it has its roots in SRI may mean that actively advocating against SRI’s ability to manage ERISA capital would harm the reputations of ESG practitioners in the long firm.

Indeed, it is easy to imagine opponents of the regulation issuing a statement condemning anyone who does not join them. If they do this, they might also embark on a media campaign casting ESG practitioners as part of the anti-impact crowd. They might try to tarnish their former associates’ images by lumping them with the traditional targets of SRI, namely the fossil fuel, defense, tobacco, gaming, and alcohol industries. This would be unfair to the ESG faction and would cement the breakup. Instead, they should affirm their commitment to growing the wealth of American workers, remove themselves from the conversation surrounding pensions, and fund research that shows the positive effects that SRI has on local communities. Classic strategy wisdom dictates that if a sector cannot compete based on financial reasons, then it should differentiate itself based on other reasons, such as higher levels of service or satisfying customers’ emotional or psychological needs. That is the whitespace that SRI needs to fill, and there are tens of trillions of dollars of non-ERISA capital available for this pursuit.

Many of the comments submitted to the Department of Labor when it published the draft version of the bill on June 30 of 2020 show that American workers and their plan administrators support this delineation. The biggest concerns were that fiduciaries be prohibited “from sacrificing investment returns to further political agendas,” that “consideration of ESG factors is permitted if the decision is based on pecuniary considerations,” and that the Department of Labor carefully “consider what parts of the regulation might be exploited by baseless class action lawsuits.” This last concern, voiced by the leading employer-sponsored benefits plan trade association, refers to the rise of frivolous but expensive class action lawsuits in which a plaintiff need find only one investment that outperformed the plan’s strategy in order to make a claim against the plan. While the first two concerns were addressed in the final rule, the American Benefits Counsel has not stated if it thinks the third problem was solved. The most important takeaway from public comments on the draft version: ESG is more popular than SRI. 

This may be ESG’s time to shine. Regardless of what happens, whether opponents of the regulation pass legislation or put new regulations in place, ESG practitioners should capitalize on this moment. This is an unprecedented time in ERISA history, with a President who seemingly wants impact investing to succeed and the main competition in impact investing (SRI) cut out of the picture. ESG product sponsors should focus on bringing as many ERISA assets under management as possible and on outperforming the market. Generating alpha is the only way to secure their position.