Navigating State Regulation of ESG Investments by Investment Managers: A Rapidly Evolving and Contradictory Landscape

June 30, 2021
9 minutes

ESG integration by retirement plans has become front and center for regulators and political leaders across the world and in the U.S. over the last 12 months. As we await further developments from the U.S. Department of Labor (DOL) on ESG issues for private sector retirement plans, a number of states have taken steps to implement ESG regulatory frameworks for their pension systems. In particular, lines in the sand have been drawn for the fossil fuel, firearms and ammunition sectors. Some states seek to restrict their pension funds from investing in these sectors, while other states seek to penalize managers that exclude investments in or discriminate against these sectors. The landscape is rapidly evolving, with legislation adopted in the last few weeks in Maine and Texas. Bills are in various stages of progress in several other states.

Complicating things for asset managers, some of the laws take opposite stances. In addition, like state laws in many subject areas, the legislation in this area is loosely drafted, raising a host of questions and interpretive issues for both managers and state officials. These laws therefore create challenges for managers to navigate in their ESG policies, marketing, funds and managed accounts.

In this Alert, we describe the state laws adopted to date, as well as various pending state initiatives. We also discuss the current state of play of the DOL’s ESG guidance.

State Efforts to Control ESG Investing by Public Pensions

At the state level, political leaders are taking varying approaches to overseeing investment decisions made by their retirement systems and companies. These approaches are discussed below and summarized in greater detail in the Appendix.

Legislation and Policies Calling For Integration of ESG Considerations in Investment Decisions

In 2019, Illinois passed legislation that required public investment leaders to incorporate ESG into their investment decisions, which was the most direct sustainable investing policy from a state up to that point. According to the Illinois state treasurer’s office, sustainability factors provide a more complete view of an investment, its past performance, and its future potential. Sustainability factors have a material impact on business performance and long-term shareholder value, and as such, investors have an interest in integrating these factors into investment decision-making processes. This requirement to incorporate ESG considerations took effect on January 1, 2020.

In September 2020, the Oregon Investment Council (OIC) approved a policy formalizing the importance of ESG factors in investment decisions, which will be considered in its $107 billion investment portfolio. The OIC oversees allocations for the state trust funds, including the Oregon Public Employees Retirement Fund, the Common School Fund, and the State Accident Insurance Fund.

Legislation, Bills and Policies Promoting Divestment from the Fossil Fuel Industry

A variation on this theme of giving sustainable business practices more consideration for investment decisions has been some states’ efforts to promote divestment from the fossil fuel industry.

On June 16, 2021, Maine became the first state to pass legislation mandating divestment of public assets from fossil fuel. H.P. 65-L.D. 99 requires the state, including its $17 billion pension fund and state treasury, to divest itself of assets invested in the fossil fuel industry by January 1, 2026.

New Jersey introduced legislation in 2020 to prohibit investment of state retirement funds in any of the top 200 companies that hold the largest carbon content fossil fuel reserves.

Also in 2020, the New York State Comptroller adopted a goal of transitioning the state’s $226 billion retirement fund to net zero greenhouse gas emissions by 2040.

Legislation and Bills Restricting Investment in Entities that Boycott the Fossil Fuel Industry

In contrast, governors and legislators from energy-producing states such as Texas, North Dakota, Oklahoma, and Alaska have adopted or proposed laws or policies limiting transactions with companies that have called for divestment from the fossil fuel industry.

Recently, Governor Abbott of Texas signed into law S.B. 13, which prohibits investment in companies that boycott certain energy companies. The law, which takes effect on September 1, 2021, directs state retirement systems such as the Employee Retirement System of Texas, the Teacher Retirement System of Texas, among other entities, to sell, redeem, divest or withdraw all publicly traded securities of a company if the company does not cease a boycott of energy companies.

Other energy-producing states like North Dakota and Oklahoma have taken a slightly different approach. In North Dakota, S.B. 2291, which was signed into law by Governor Burgum on March 23, 2021, requires the state’s department of commerce to undertake a study of ESG as it pertains to a set of nonspecific, quantifiable, and nonquantifiable criteria for making decisions or investments as it pertains to government and private industry in North Dakota. The study must also include the potential implications for the state as it relates to the boycott of energy or production of agriculture commodities by companies that intend to penalize, inflict economic harm on, or limit commercial relations. In Oklahoma, H.B. 2034, which was sent to committee in March 2021, intends to prohibit state contracts with a company unless the company submits a written certification that the company is not currently engaged in a boycott of the oil and gas industry.

Bills Pertaining to Investments in Firearms and Ammunition Companies – For and Against

As with fossil fuel investments, there have been efforts by state legislatures – from both sides of the political spectrum – to oversee investments in firearms and ammunition companies.

In Massachusetts, H.43 was introduced in April 2021 to require public pension fund divestment from firearms and ammunition companies.

In contrast, in Texas, S.B. 19 was signed into law on June 14, 2021, which prohibits contracts with companies that discriminate against the firearms or ammunition industries. The law applies to contracts paid partly or wholly from public funds between government entities and companies. Under the law, which takes effect on September 1, 2021, a Texas governmental entity, such as the various public retirement systems, is not permitted to enter into a contract with a company unless the company provides written verification that it does not have a policy of discriminating against firearms companies solely because of their status as such.

ESG Investing by ERISA Retirement Plans: The DOL’s Changing Guidance

The “Current” Regulation

In Fall 2020, the DOL adopted a final regulation that amended ERISA’s investment duties rule articulating how a fiduciary can satisfy his or her duties of loyalty and prudence in selecting plan investments. This was the latest change in law after years of issuing sub-regulatory pronouncements going back to 1994.

The 2020 final regulation, which was best understood as an incremental expansion of the DOL’s longstanding guidance in this area, explained how ERISA plan fiduciaries must make investment decisions solely based on the financial interests of plan participants, and not on collateral issues such as ESG aims (outside of rare “tie-breaker” scenarios between two otherwise equivalent investments).

The final regulation states that when selecting plan investments, ERISA fiduciaries may only consider so-called “pecuniary factors.” A “pecuniary factor” is a factor that the fiduciary prudently determines is expected to have a material effect on the risk and/or return of an investment based on appropriate investment horizons consistent with the plan’s investment objectives and funding policy. In addition, the fiduciary must ensure that when it assigns relative weights to these pecuniary factors it bases those weights on a prudent assessment of the impact of each factor on risk and return. The final regulation also flatly prohibits qualified default investment alternatives that use non-pecuniary factors as part of the product’s investment goals and principal investment strategies.

Interestingly, the final regulation does not use the term “ESG” or define it in any way—and there is no per se prohibition on selecting investment strategies that incorporate ESG as long as they are selected based on pecuniary factors.

Prior Guidance – A Seesawing Approach

As noted above, prior to last year’s final regulation, the DOL had released several pieces of guidance over the last three decades in response to the concern that a fiduciary’s decision to select an ESG investment could inherently violate his or her duties under ERISA, because ERISA requires that the fiduciary act for the exclusive benefit of plan participants. In response to this concern, the DOL issued an “interpretive bulletin” in 1994, which said that a fiduciary may consider a collateral benefit (such as ESG) as a deciding factor in a tie-breaker scenario—but only if the fiduciary determines that the investment with the collateral benefits is expected to provide fundamentally the same investment return as available alternative investments with similar risk characteristics, and if the investment is otherwise appropriate for the plan in terms of diversification, the investment policy, etc. This is often referred to as the “all things being equal” standard for ESG-themed investments.

Starting in 2008, the DOL began issuing more sub-regulatory guidance on ESG investments. The DOL’s view of ESG investments shifted back and forth over the next decade—first saying that a fiduciary’s consideration of ESG factors should be “rare,” then saying that ESG could be a valid financial factor for a fiduciary to consider even in the absence of a tie-breaker situation. ESG investments came under particular scrutiny during the Trump administration, which included a DOL enforcement initiative that asked plan sponsors for information about their ESG investments. This scrutiny culminated in a proposed regulation, which was issued in June 2020 and, following an unusually short comment period, the final regulation described above, was released last Fall.

A New Administration, a New Position

The final regulation took effect in January 2021. However, following the change in presidential administration, the Biden-led DOL issued a non-enforcement policy less than two months later saying it would not enforce the final regulation or pursue actions against a fiduciary on the basis that they failed to comply with it. Then in May 2021, President Biden issued an executive order on climate-related financial risk, which asked the Secretary of Labor to “consider publishing, by September 2021…a proposed rule to suspend, revise, or rescind” the final regulation. Consequently, ESG investing by ERISA plans remains in a state of flux at the Federal level.

Until the DOL issued its non-enforcement policy in March, the final regulation was expected to require asset managers to reassess how they market their ESG capabilities and philosophies, and if necessary, to make changes in how the investment decision-making process would be documented. The rule posed particular challenges to managers who are also subject to the EU’s rules (including the Sustainable Finance Disclosure Regulation or SFDR), and navigating the intersection of these rules would require care and special consideration. But now with this non-enforcement policy and President Biden’s executive order in May, it is clear that the legal framework governing ESG investments by ERISA plans will continue to evolve. Asset managers will need to watch the DOL’s activity closely over the coming months to see how this story unfolds.


It is critical that investment advisers, registered investment companies, and private funds that currently offer or intend to offer ESG products and services to governmental pension plans and/or ERISA retirement plans assess the impact of the recent and developing state laws and the DOL’s activities discussed in this Alert. They also must remain vigilant in continuing to monitor developments in this area of law.

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