Battles Over ESG in 401(k)s Will Outlast Judge’s Surprise Ruling

The decision late last week by a Trump-appointed judge to allow a contentious ESG-themed 401(k) Biden administration rule to stand is a major blow to “woke” investing critics, but it appears unlikely to quell fervent political opposition to do-good investing strategies.

US District Court for the Northern District of Texas Judge Matthew J. Kacsmaryk Sept. 21 granted the US Labor Department’s cross-motion for summary judgment in a case brought by more than two dozen red-state attorneys general. The ruling effectively green lights a regulation (87 Fed. Reg. 73822) allowing workplace retirement plans to consider environmental, social, and corporate governance factors when selecting and monitoring investments on behalf of participants.

Although significant, particularly considering Kacsmaryk’s conservative track record, the Texas case once considered the GOP’s best shot at undoing the Biden rule is now just one piece of a bigger partisan push to scrub ESG consideration among Wall Street asset managers. Republicans on Capitol Hill are now investigating public coffers, retail portfolios, and proxy voting firms over their ESG treatment.

That political pressure has inadvertently caught a seemingly benign DOL regulation in an effort to shape nearly $30 trillion in investment capital and the returns of more than 140 million workplace savers. With the stakes so high, the department’s rule itself may be safe for now, but the future holds uncertainty.

“In the short term, this is a very major step in protecting the future of the Biden administration’s rule,” said Josh Lichtenstein, a partner at Ropes & Gray LLP in New York. “In the long term, the way this has been treated as a political issue isn’t likely to change.”

‘Little Meaningful Daylight’

Last week’s decision supports the Labor Department’s position that political consternation swirling around its rule can be chalked up to a poor understanding of what it actually does. The department has said it sought to strike a neutral tone on ESG factors in retirement funds.

DOL’s Employee Benefits Security Administration replaced Trump-era rules earlier this year, claiming they had a “chilling effect” on the consideration of ESG factors, even when they were financially relevant. Yet, the department insisted the two regulatory regimes weren’t all that different. Under both regulations, ESG investments are permissible when plan decision-makers held to a strict fiduciary standard of care prudently determine they’re financially material.

Kacsmaryk seemed to agree with that argument, writing in a 14-page decision that there is “little meaningful daylight” between the two rules.

The judge borrowed from an amicus brief filed by former Obama-era Deputy Assistant Treasury Secretary Mark Iwry, who made the case that there are two types of ESG analyses—those which seek to maximize financial returns and those that are aimed at collateral benefits. The department’s rule only permits ESG investments that are intended to improve participants’ financial footing.

“There might be areas where there are reasonable disagreements in ESG investing, but retirement plans are not one of them,” said Jason Levy, of counsel at Covington & Burling LLP and a member of the team that filed Iwry’s brief. “Ultimately, it’s impermissible to consider ESG factors for collateral purposes, and that’s what’s important here.”

A DOL spokesperson said the department is “pleased with the judge’s decision.” The Utah Attorney General’s office, which acted as lead plaintiff in the case, said officials are “evaluating next steps, including potential appeal.”

“We filed this suit to ensure that the Department of Labor follows the law in requiring retirement and pension plans to make decisions for the benefit of plan participants, not social or political priorities,” the attorney general’s office said.

Litigation and Legislation

The department’s rule still faces a Wisconsin federal court review and renewed political pressure from Republicans in Congress taking their second crack at codifying a pair of Trump administration anti-ESG policies.

Biden was forced to exercise his veto authority for the first time earlier this year defending the DOL’s ESG rule from a congressional attempt to eliminate it. House Republicans advanced legislation Sept. 14 that would amend decades-old benefits law in order to prohibit workplace fiduciaries from considering immaterial investment factors.

Meanwhile, anti-ESG politics have already produced at least one private-sector lawsuit targeting an American Airlines Group Inc. 401(k) plan, and benefits observers expect more.

State plaintiffs in the case may also face an uphill challenge if they do appeal the case to the US Court of Appeals for the Fifth Circuit, which has several Trump appointees on the bench. EBSA fought and lost an Obama-era attempt to preserve the department’s highly controversial fiduciary investment advice rule there.

But the red states’ loss in Kacsmaryk’s court is still a consequential one. His bench is widely considered one of the country’s most conservative, and he has been responsible for undoing a number of Biden regulations, including federal approval for the abortion drug Mifepristone earlier this year.

“If you can’t get the case past this judge, who can you get it past?” said Kristina Zanotti, a partner at K&L Gates LLP in Washington.

Kacasmaryk, who expressed sympathy for the plaintiffs in his ruling, pointed out that the Biden ESG rule stands under “current law.”

His analysis also relied heavily on giving the department deference under the Chevron doctrine, a principle that often gives agencies the benefit of the doubt in close cases under the Administrative Procedure Act (Pub. L. No. 404-79). A Supreme Court supermajority is poised to undo that doctrine as early as next term, some legal analysts believe, a move that might cast more doubt on the ESG rule’s future survival in court.

“I think there’s still quite a lot of hesitancy,” said Zanotti. “It’s such a political issue, and it raises the risk of private-sector litigation. I don’t think all of a sudden everyone’s going to start feeling free to consider ESG factors after this ruling.”

The case is Utah v. Walsh, N.D. Tex., No. 2:23-cv-00016, ruling issued 9/21/23.