Labor Agency to Defend ESG 401(k) Rule in Bad-Blood Jurisdiction

The US Labor Department is facing an unwelcome case of litigation deja vu, as its attempt to implement a climate-friendly retirement investment rule encounters legal peril in a Texas federal court jurisdiction known for striking down consequential employee benefit regulations.

More than two dozen Republican state attorneys general are hoping history will repeat itself in their quest to kill a DOL final rule, this one permitting private-sector employers to consider environmental, social, and corporate governance factors when choosing pension investments.

That policy, now under review by the US District Court for the Northern District of Texas, is scheduled to take effect Jan. 30. But the AGs’ lawsuit filed late Thursday sought to freeze the rule and ultimately block regulators from enforcing it at all.

It’s a difficult scenario for the DOL’s Employee Benefits Security Administration, which saw similar lawsuits originating in Texas federal court undermine the landmark Obama-era fiduciary rule in 2018. An unfriendly court could disrupt a years-long effort by the Biden administration to eliminate the stigma surrounding ESG retirement investing and at the same time provide traction to a growing red state-led effort to squash “woke” investments in public sector portfolios.

“There’s a big picture issue here about the role of the federal government versus the role of the states,” said Brad Campbell, a Faegre Drinker Biddle & Reath LLP employee benefits partner and former DOL assistant secretary for employee benefits. “Jurisdiction is key here.”

Venue Shopping

Thursday’s lawsuit in Texas, brought by a group co-led by the state’s Attorney General Ken Paxton (R), clearly signals that the 25 red states suing the department shopped for a friendly venue, according to Campbell.

The case is now within the ultimate purview of the US Court of Appeals for the Fifth Circuit, which in 2018 vacated a major DOL rule redefining an investment advice fiduciary under the Employee Retirement Income Security Act of 1974 (Pub.L. 93-406). Like Thursday’s suit, plaintiffs challenging the fiduciary rule accused EBSA of exceeding its statutory authority by proffering an arbitrary and capricious rule.

“What happened with the fiduciary rule was devastating to the Labor Department,” said Josh Lichtenstein, an employee benefits partner at Ropes & Gray LLP.

Meanwhile, the Northern District of Texas is already considering a challenge a consumer rights group has brought against the department for its fiduciary rule exemption that would require newly regulated broker-dealers to consider the best interest of plan participants and beneficiaries rolling over their assets into an annuity or other off-the-shelf financial product.

Judge Matthew J. Kacsmaryk, a Trump appointee who has been assigned to the state-led ESG suit in district court, has been responsible for undoing a string of Biden federal actions, including a Health and Human Services Department attempt to bar family planning providers from telling parents about their children requesting birth control, and a Biden effort to prohibit LGBTQ discrimination in health-care settings.

The Fifth Circuit bench, already considered one of the nation’s most conservative, has also landed a handful of key Trump administration appointees.

The Labor Department deferred Bloomberg Law’s requests for comment on the ESG case to the US Justice Department, which is responsible for defending the agency. DOJ officials didn’t immediately respond to a similar request. Lead state plaintiffs in the case either didn’t respond or declined to comment to Bloomberg Law.

Asked if plaintiffs had sought the Fifth Circuit intentionally, an attorney representing a retirement plan investor said the complaint “speaks for itself.” The attorney, Anna St. John, president and CEO of the Hamilton Lincoln Law Institute, pointed to instances of Democratic attorneys general seeking liberal courts.

Any federal judge should attempt impartiality, said Kristina Zanotti, a partner at K&L Gates LLP, but the Labor Department’s track record in Fifth Circuit courts lends credibility to an emerging perception that it’s where Labor Department retirement rules go to die.

“It brings attention to a case like this for sure,” Zanotti said.

Standing Question

But the Labor Department may have an easier time defending its ESG rule than its fiduciary rule, even in an often hostile circuit, according to ERISA attorneys.

The fiduciary rule sought to extend DOL’s regulatory authority to financial advisers and broker-dealers who usually operated outside its reach, said Campbell, who led the benefits agency under former President George W. Bush.

“Rather than have a political ping-pong game about whether ESG is good or bad, the proposal the Biden administration has put out restores the traditional approach of government neutrality,” he said.

The final ESG rule eliminated a proposed provision that would have “often required” that an ERISA plan fiduciary consider socially conscious investment factors.

That move by the DOL may make it more difficult for the plaintiffs to show that they’ve sustained reparable damage, as the rule returns investment control back to retirement plans that have historically been held to duties of prudence and loyalty.

The question of standing persists when factoring in who the plaintiffs are—25 state governments. State pensions are specifically preempted from ERISA regulation. Plaintiffs in the ESG case claim “special solicitude” to sue because their residents could suffer financial harm under the department’s rule, and that could impact states’ tax-derived bottom lines.

Many of the same states suing the department are simultaneously ridding their own government-sponsored pension plans of any ESG investment criteria and even shunning companies that market socially and environmentally conscious funds. So far, asset managers like BlackRock Inc. and State Street Corp. have received the brunt of red state anti-ESG rhetoric, but the motivation behind the new lawsuit may be purely political, said Lichtenstein.

“These states are looking at the same prudence and loyalty standards that the DOL is and they’re coming out in a radically different direction,” he said. “If they succeed in getting this rule thrown out in court, it makes their interpretation look more credible. But even if they don’t succeed, they’re getting this idea of a flat prohibition on ESG investing out into the public discourse.”

The case is Utah v. Walsh, N.D. Tex., No. 2:23-cv-00016.