Outreach Blog

Sunday, December 20, 2020

Compliance with the DOL's New Proxy Rules May Stump ERISA Fiduciaries

A counter-revolution in ESG Investing?

Author: David Schwartz J.D. CPA

On Friday, December 11, the Department of Labor (DOL) issued its final rules on proxy voting by ERISA fiduciaries. As proposed last August 30, the draft rules drew hundreds of responses by the ESG-directed investing community, many of which criticized the proposal as unworkable. The final version of the rules eliminates the proposal's rigid requirements for plan sponsors to weigh the economic vs. non-economic effects before casting their proxy votes. Yet that softer, principles-based approach may itself create compliance problems for ERISA fiduciaries -- and may not even survive the first hundred days of the Biden administration.

Commenters seem to have persuaded policy-makers at DOL that compliance with the original draft rules would have been too costly and complex to implement. Rather, the Labor Department focused the final rule on "whether a fiduciary has a prudent process for proxy voting and other exercises of shareholder rights" as a more workable framework for achieving the DOL's objectives. 


What is the Purpose of the Rules?

What were the DOL's stated objectives with its new proxy guidelines? The DOL sought to rectify a "persistent misunderstanding" that ERISA fiduciaries must vote all proxies. According to Jeanne Klinefelter Wilson, acting assistant Secretary of Labor for the Employee Benefits Security Administration, these new proxy restrictions are meant to ensure that ERISA fiduciaries are only expending resources researching and voting proxies that have a financial effect on the plan:


"The plan fiduciary must never subordinate the interests of participants and beneficiaries in their retirement income to unrelated objectives, including promoting non-pecuniary goals or benefits."


What do the Rules Require?

The final proxy voting rule makes clear that fiduciaries are not required to vote every proxy. It outlines six points a fiduciary must undertake when making decisions on exercising shareholder rights, like proxy voting:

  1. Act solely in accordance with the economic interest of the plan and its participants and beneficiaries.
  2. Consider any costs involved.
  3. Not subordinate the interests of the participants and beneficiaries to any non-pecuniary objective.
  4. Evaluate material facts that form the basis for any particular proxy vote.
  5. Maintain records on proxy voting activities and other exercises of shareholder rights.
  6. Exercise prudence and diligence in the selection and monitoring of proxy advisory firms.[1]


The DOL's new rules have two safe harbor provisions. ERISA fiduciaries adopting at least one of these policies will be considered to have satisfied their responsibilities when deciding whether to vote proxies.  

  1. Adopting a policy that proxy voting resources will focus "only on particular types of proposals that the fiduciary has prudently determined are substantially related to the corporation's business activities or are expected to have a material effect on the value of the plan's investment."
  2. Refraining from voting on proposals when the size of the plan's holdings in the stock subject to the vote are below quantitative thresholds that the fiduciary prudently determines.[2]

Fall-out Effects on Fiduciaries

Securities Lending.  Even with the change to a more principles-based regime from the rules as proposed, these new requirements can be a hardship on ERISA fiduciaries and costly to the plans they manage. Outside of the safe harbors, the complex calculus an ERISA fiduciary must now engage in for each and every proxy voting decision just became more time-consuming and expensive. Plus, ERISA plans with securities lending programs may find their previous discretion regarding whether to recall loaned securities to vote their proxies has been all but eliminated. As SIFMA pointed out in their comment letter on the proposal: 


"Moreover, there may be logistical challenges with determining the economic benefits of some proposals. For example, when an institution lends shares under a securities lending program, it cannot generally vote those shares at an upcoming shareholder meeting if the shares are on loan on the record date to identify voting rights. Because the institution may not know what will be on the meeting agenda until after the record date, it would not be able to perform a rigorous "economic analysis" to determine whether the benefits of recalling or objective costs associated with a recall or restriction, the likely outcome is that these shares would not be voted." [3]

Voting ESG Proxy Matters.  Despite numerous mentions in the rule's preamble, the term "ESG" is not mentioned anywhere in the rule text. According to the DOL, The lack of a precise or generally accepted definition of 'ESG,' either collectively or separately as 'E, S, and G,' made ESG terminology not appropriate as a regulatory standard. . . The focus on the final rule is on whether a factor is pecuniary, not whether it's an ESG factor." [4]   Nonetheless, ERISA fiduciaries are going to find it difficult to justify voting proxies for a whole host of issues that are not so clearly tied to a pecuniary benefit to the fund. The DOL counters, however, that voting on ESG-related proxies is still an option. Jeanne Klinefelter Wilson, acting assistant Secretary of Labor for the Employee Benefits Security Administration said of the rules:


"Now, this does not mean that fiduciaries are prohibited from considering such issues as environmental impact and workplace practices when they are relevant to the financial analysis. Because these issues are pecuniary in that instance, and therefore appropriate considerations under the rule."


On the other hand, it is fairly well known that these rules arise out of the perceived skepticism of ESG by the current administration. George Michael Gerstein, co-chairman of the fiduciary governance group at Stradley Ronon Stevens & Young recently said of the rules:


"I think many view as being the impetus for the financial factors rule and this rule and that it was designed to target ESG in some way," Mr. Gerstein said, referencing a Labor Department rule that was finalized in October and requires ERISA plan fiduciaries to select investments based on pecuniary factors. "I think the DOL has at least attempted to allay those concerns but the devil is ultimately going to be in the details, which is whether the rule has enough clarity that it's not going to chill activity that was otherwise commonplace."[5]


During the comment period, ERISA fiduciaries like TIAA urged the DOL to soften its apparent stand against ESG investing. In their comments, TIAA argued that ESG factors do not always have an immediately discernable pecuniary effect, but rather can enhance a company's shareholder value in less tangible ways like risk reduction and reputational value. They also noted that the rules as proposed (and ultimately adopted) make these kinds of considerations more, not less, difficult for ERISA fiduciaries. 


"while not every ESG issue subject to a proxy vote has economic implications, ESG factors are often in direct alignment with a company’s pecuniary considerations – and thus it is often the case that voting proxies on ESG-related issues is in the economic interest of investors."  

"Given the direct link that can exist between a company’s financial performance and its handling of  ESG  factors,  we believe plan fiduciaries are well justified in expending resources to make careful informed proxy voting decisions on  ESG-related items on behalf of plans and plan participants. The Proposed Rule would make it even more expensive and difficult for plan fiduciaries to make these voting decisions."[6]


Will the Rule Survive? 

Successive administrations have fought over how often ERISA fiduciaries must undertake this cost-benefit analysis concerning proxy voting and other shareholder rights, making new rules and moving the goalposts with each new Secretary of Labor. Presumably, President Biden's administration will swing policy back to a more favorable posture to ESG investing and proxy voting by ERISA fiduciaries. Given the outcry against this rulemaking, it would not be at all surprising if the new DOL leadership amends or repeals these burdensome proxy rules. 



[1] DOL Fact Sheet, https://www.dol.gov/sites/dolgov/files/ebsa/about-ebsa/our-activities/resource-center/fact-sheets/fiduciary-duties-regarding-proxy-voting-and-shareholder-rights-final-rule.pdf

[2] Ibid.

[3] SIFMA Comment Letter https://www.dol.gov/sites/dolgov/files/EBSA/laws-and-regulations/rules-and-regulations/public-comments/1210-AB91/00261.pdf

[4] DOL Fact Sheet, see note [1] above.

[5] https://www.pionline.com/regulation/dol-finalizes-rule-proxy-voting

[6] TIAA Comment Letter https://www.dol.gov/sites/dolgov/files/EBSA/laws-and-regulations/rules-and-regulations/public-comments/1210-AB91/00266.pdf 



The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting