A group of 25 Republican attorneys general sued Labor Secretary Marty Walsh and the Labor Department over a Biden administration regulation that gives retirement plan sponsors more freedom to consider environmental, social and governance factors when selecting investments.

The final rule, which went into effect this week, remains in force during the legal challenge, as the financial services industry ramps up an effort to offer ESG-focused retirement plans to more Americans.

The complaint, filed Jan. 26, argues that the department’s rule, released in November, undermines key protections for retirement savings and oversteps the department’s statutory authority under a 1974 law known as the Employee Retirement Income Security Act, which governs a broad range of retirement and health benefit plans.

The lawsuit asked the court to toss the ESG rule, calling it “arbitrary and capricious” and a violation of both ERISA and the Administrative Procedure Act.

“The 2022 Investment Duties Rule contravenes ERISA’s clear command that fiduciaries act with the sole motive of promoting the financial interests of plan participants and their beneficiaries,” according to the lawsuit, filed in the U.S. District Court for Northern District of Texas, Amarillo division.

“DOL does not adequately justify its decision to permit fiduciaries to consider nonpecuniary factors when making investment decisions or exercising shareholder rights,” the lawsuit continued. “By formally injecting ESG concepts into the ERISA prudent duty regulations, DOL has ventured into territory that Congress explicitly rejected when it drafted ERISA.”

The plaintiffs include Texas, Florida and West Virginia, as well as oilfield services firm Liberty Energy; Western Energy Alliance, an oil and natural gas trade association; and James R. Copland, a senior fellow at the Manhattan Institute who is a participant in a retirement plan subject to ERISA.

A spokesperson for the Labor Department referred CQ Roll Call to the Justice Department, where a spokesperson declined to comment.

The rule reverses a Trump administration change in 2020 to the implementation of ERISA. The Biden administration, investors and other ESG proponents had said the Trump administration changes created a “chilling effect” on investors that wanted to include sustainable investments in retirement plans.

The legal action marks the latest move from Republicans to shrink ESG’s role in financial decision-making, under the argument that factors such as climate change are immaterial and politically motivated. 

“Permitting asset managers to direct hard-working Americans’ money to ESG investments puts trillions of dollars of retirement savings at risk in exchange for someone else’s political agenda,” Utah Attorney General Sean Reyes, a Republican, said in a statement.

‘Broadest preemption’

The federal regulation’s interpretation of what it means to be a prudent fiduciary is actually agnostic toward ESG factors, said Josh Lichtenstein, ERISA partner at Ropes & Gray LLP. But the law itself is pretty powerful, he said.

“Congress gave ERISA a very broad preemptive effect, some of the broadest preemption under federal law,” Lichtenstein said in an interview. “It preempts all state laws relating to retirement plans. States challenging the ability for the Department of Labor to make rules that govern how those assets are invested, it’s really contrary to what I would say are the normal operation of ERISA.”

The exceptions are state employee pensions and retirement funds, which may use ERISA as a template but are not governed by the law. The final rule has no effect on those plans.

Lichtenstein said the lawsuit is part of “a more generalized attack on ESG,” including states restricting the state employee funds from this kind of investing. “This is part of a broader trend to contain the ability of regulators to regulate,” he said.

So far in 2023, lawmakers in Utah, South Carolina, Indiana and Virginia have introduced legislation to restrict the use of ESG factors in selecting investments in pensions and other state-run retirement plans. 

Legislatures in New York, Oregon, Washington, Massachusetts and Connecticut, meanwhile, are proposing rules to embrace ESG factors and divestment of certain industries in public funds and retirement plans. 

“This divergence in approach between federal and state law (and among states) can create particular challenges for asset managers that need to balance the demands of benefit plans subject to the laws of such states and those benefit plans subject to ERISA,” according to a client note from Latham & Watkins LLP’s ESG and executive compensation practices.

“Navigating these complications in the investment landscape will be an increasingly important consideration for investment managers seeking investments from both employee benefit plans subject to ERISA and those subject to state and local laws,” said the note, led by the firm’s partners Sarah E. Fortt, Betty M. Huber and Benjamin Rosemergy.

Despite the tension and legal uncertainty, some companies are moving ahead on plans to provide offerings catering to retirement savers who want ESG.

Morningstar announced this week its investment research subsidiary’s retirement solutions team and retirement plan administrator Plan Administrators Inc. officially launched the Morningstar ESG Pooled Employer Plan, which is designed to select funds that limit exposure to material ESG risks.

“The Department of Labor ruling is a great win for employers and advisors as it gives them options to choose investments that not only provide an appropriate diversification and return profile but also gets employees engaged with their retirement savings and comfortable that their investments are being mitigated against long-term ESG risk,” said Brock Johnson, president of global retirement and workplace solutions at Morningstar Investment Management.

The Labor rule also faces challenges from lawmakers.

Sen. Mike Braun, R-Ind., said Wednesday he will introduce legislation to block the Labor Department’s new rule with support from all 48 other GOP senators and Sen. Joe Manchin III, D-W.Va.

Braun brought up similar legislation in the previous Congress, though this time he has the support of Manchin, whose moderate views have been a sticking point for Senate Democrats. According to Braun, the bill is a disapproval resolution that will require only a simple majority vote to pass instead of the usual Senate threshold of 60 votes.

“I’m proud to join this bipartisan resolution to prevent the proposed ESG rule from endangering retirement incomes and protect the hard-earned savings of American families,” Manchin said in a statement Wednesday. “I encourage my colleagues on both sides of the aisle to support this important resolution to ensure Congress is promoting economic security for West Virginians and Americans, not further exacerbating the serious economic challenges they are already facing.”

House Democrats, meanwhile, last week announced the formation of the Congressional Sustainable Investment Caucus, which will focus on educating other lawmakers on the benefits of ESG investing and engaging with investors, fund managers, companies and regulators on policy issues.

Democrats maintain that certain ESG issues are just as relevant as more traditional financial factors and that barring consideration of them will hurt Americans’ savings in the long run. Rep. Sean Casten of Illinois, who is co-chair of the new caucus with Rep. Juan C. Vargas of California, said it’s critical that lawmakers become more knowledgeable about ESG investing with Republicans now in charge of the House.

“We are creating this caucus for defensive reasons,” Casten said. “One of the oldest rules of Washington is that losers always cry louder than winners cheer. … When capitalism is working well but you’re not winning, you tend to call it woke capitalism. It’s still capitalism.”