Compliance May 26, 2022

Facing Criticism for ESG Rules, SEC Unlikely to Back Down

Attorneys who track financial regulations say SEC Chair Gary Gensler has no qualms about pushing forward big, ambitious proposals, even if they are destined to be challenged in the courts.
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Art by Parapaboom


Earlier in May, the Securities and Exchange Commission extended the comment period on its proposal to make key rule amendments that would require domestic or foreign registrants to include certain climate-related information in its registration statements and periodic reports, such as on the Form 10-K.

Examples of the information to be disclosed by securities issuers include climate-related risks and their actual or likely material impacts on the registrant’s business, strategy and outlook. Other information to be disclosed includes the registrant’s governance of climate-related risks and relevant risk management processes, as well as the registrant’s greenhouse gas emissions.

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The comment deadline extension came after the regulator received substantial criticism regarding the original 30-day window, with many financial services industry stakeholders requesting more time to digest the proposal and prepare their formal response. While the extension to June 17th will provide supporters and critics more time to prepare comments about the environmental, social and governance proposal, Amy Greer and Jennifer Klass, co-chairs of Baker McKenzie’s financial regulation and enforcement practice, already believe the SEC’s final rules are destined to be challenged in the courts.

Greer is the former chief trial counsel at the SEC’s Philadelphia regional office, while Klass formerly served as vice president and associate counsel at Goldman Sachs & Co. Based on their conversations in the marketplace, they say the most controversial aspects of the ESG-focused rulemaking—as proposed—relate to “Scope 3 emission disclosures” that some believe exceed the SEC’s authority. As commonly defined, Scope 3 emissions are those produced as a result of activities from assets not owned or controlled by the reporting organization, but that the organization impacts in its value chain and business operations.

Why Scope 3 Is Controversial to Some

Critics of this part of the proposal say mandating disclosures up and down the supply chain of stock issuers spills into environmental policy and seeks to drive specific behavior, the attorneys say. Therefore, they argue, this proposal is an overreach for a regulator like the SEC, which has not been specifically directed by Congress to develop and enforce environmental regulations.

Those who support the SEC’s actions, on the other hand, argue that the SEC is fully empowered to require many different types of disclosures from securities issuers, and that individual and institutional investors are demanding these types of disclosures in the normal course of their market participation. They also point out that those who think ESG topics are being over-valued in the current and future price of securities could just as easily use the mandated Scope 3 data to inform their own investment decisions.

“As you would imagine with this topic, many comments have been submitted already, and the comments are coming from across the board, speaking both to the procedural aspects of the rulemaking and to the substance of the proposal,” Klass says. “This is all coming during a busy time for the SEC. They have been very active, putting out a variety of new rules with short turnarounds in terms of the comment periods. For example, the private funds disclosure proposal has also generated a lot of attention and commentary.”

As Greer and Klass point out, the SEC leadership has clearly signaled its intention to work to improve ESG-related disclosures, and they can be expected to factor ESG themes into multiple rulemaking actions. Since its original proposal, the SEC has already followed up on the broad ESG disclosure package with two additional regulations, one aimed at mandating similar types of disclosures on the part of registered investment advisers and fund managers and the other restricting and regulating the use of the ESG label in fund names.

Greer says the substantial debate surrounding the SEC’s ESG proposal is no great surprise in the current political and legislative context. As the volume of comments demonstrates, whatever the venue, whether in Congress or within the walls of an executive branch regulator, the topic of ESG generates significant debate here in the United States—far more than in other regions of the world.

The SEC Will Fight for ESG Disclosures

“One thing I think we can say is that SEC Chair Gary Gensler is not afraid of the controversy generated by these proposals,” Greer adds. “We can also say he came to this position with a very heavy rulemaking agenda, prepared for him by the Biden administration. My impression is that he has really felt the need, I think, to not only ‘check the boxes’ on the task list he was given, but also to address issues as they arise. For example, we have seen this with the focus on cryptocurrencies and the emergency of tech-based retail investing platforms popularized during the COVID-19 pandemic.”

In this context, Klass and Greer say, the ESG proposal is almost guaranteed to face challenges in court, with plaintiffs raising all sorts of issues. At this early stage, the attorneys suggest, it is mere speculation to guess what the ultimate fate of the regulation may be. Even if it is ultimately blocked or curtailed by the federal courts, however, the fact that these proposals have been put forward will have a lasting impact, Klass and Greer say.

“I do think that the mere fact that the highly detailed and ambitious ESG proposals have come out will have an impact in terms of providing some guidance about how such disclosures can or should be done,” Klass says. “Many U.S. issuers have been looking for guidance about what is the right framework to adopt. If nothing else, the proposal reflects what the current SEC sees as appropriate. It gives issuers something to think about in terms of how they disclose ESG practices.”

As clients increasingly demand ESG-related information from stock issuers, competitive pressures will continue to play a key role, driving many issuers to put forward much of this information voluntarily. The attorneys also point out that, even without the proposed rules and client demands, failure to keep up with the marketplaces’ treatment of climate-change-related disclosures could create potential liability exposure under current SEC rules.

The idea is that, if a significant percentage of the investment community continues to take a position that certain climate-related information is material and that climate-related disclosures are important to an investment analysis, omitting such information could raise potential Rule 10b-5 concerns, for example. Part of the debate moving forward will focus on where to draw the line of materiality with regards to climate change disclosures. As it stands now, Klass and Greer say, the prescriptive nature of the SEC’s proposed rules takes a broad view as to what information concerning climate change may be material for investors.

Compliance May 23, 2022

Is the Traditional Fiduciary Insurance Model at Risk?

One legal professional at a fiduciary insurance firm argues that the ‘indiscriminate nature’ of recent ERISA lawsuit filings could eventually culminate in a crisis for the retirement plan industry’s current approach to risk management and fiduciary insurance.
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Regular readers of PLANADVISER will know that retirement plan litigation is a frequent topic of coverage for the publication, and that there has been no shortage of lawsuits to report on. Far from it, in fact.

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As noted by Daniel Aronowitz, managing principal at the fiduciary insurance firm Euclid Fiduciary, the pace of filings in 2022 has been extremely rapid, with at least 25 cases filed in the first four months of the year. Aronowitz expects to see anywhere from 75 to 100 cases filed by the end of 2022, and that most of them will come from plaintiffs represented by the same law firm: Capozzi Adler, out of Harrisburg, Pennsylvania.

His projection is comparable to the approximately 99 cases filed in 2020, when their frequency spiked. The number of cases dipped to at least 49 last year, with the exact number of cases depending on the specific type of action one defines as an ERISA excessive fee case, Aronowitz says. For Euclid, this category includes class actions that target investment underperformance of a defined contribution investment option, even if the case does not technically allege excess fees as one of its primary claims. 

“We have seen some speculation that the rate of cases declined in 2021 as plaintiff firms waited on the Supreme Court to decide the Northwestern case,” Aronowitz says. “The real difference was that the Capozzi law firm filed over 40 cases in 2020, but it filed only 11 cases in 2021. The firm appears to be back with a vengeance in 2022, however, filing 16 of the first 25 cases this year. This tiny law firm with only seven ERISA lawyers—and only $3.9 million in their own sponsored defined contribution plan—has terrorized corporate America by continuing to file the majority of recent excessive fee cases.”

Aronowitz’s criticism may seem harsh to someone not well-versed in the ERISA fiduciary risk management world, particularly given the optics involved in ERISA excessive fee cases. Generally speaking, firms representing the interests of ERISA plaintiffs say they are doing important consumer protection work on behalf of novice investors whose life savings are tied up in the DC plan system. For its part, Capozzi Adler declined to be interviewed or to answer written questions about their litigation philosophy and strategies for this article.

In essence, Aronowitz believes that Capozzi Adler’s main goal in pursuing its highly aggressive litigation agenda—with such a small team of attorneys seeking to represent so many distinct groups of clients in highly complicated and legally demanding matters—is simply to secure settlements and generate sizable attorneys’ fees. As a general rule, plaintiffs’ firms can take up to a third of the gross settlement amount in any given case, and many of the cases involve settlement demands in the millions of dollars. 

“The plaintiffs’ bar continues to file fiduciary malpractice lawsuits alleging excessive recordkeeping fees based on exaggerated fees—based on flawed representations of the fees participants are actually paying,” Aronowitz says. “They are taking advantage of the fact that most federal court judges are not highly experienced experts in ERISA fiduciary litigation. Such cases might represent only a few percent of their annual case load, and so they are naturally hesitant to dismiss such cases prior to discovery, especially given the consumer protection rhetoric that is used to dress up the complaint.”

Aronowitz suggests that the immediate aftermath of the Supreme Court’s Hughes v. Northwestern excessive fee decision has not been helpful to plan sponsors. Even before this ruling, courts denied most motions to dismiss, using a “minimal threshold” standard to evaluate the plausibility of excessive fee and underperformance claims. Aronowitz says he worries the hurdle for motions to dismiss has been moved even higher by the Supreme Court, and he expects settlements to continue apace.

“The most common excess fee claim filed this year is against plans that allegedly have high recordkeeping fees and investments in high-fee retail share classes, led by a concerted attack against plans in the active Fidelity Freedom target-date funds,” he explains. “From our perspective on the fiduciary insurance side, the most concerning development is that plaintiffs have been filing cases challenging isolated actively managed investments in plans with otherwise low fees.”

Specifically, Aronowitz takes issue with the fact that Capozzi Adler’s cases allege excessive fees based on the total compensation paid to recordkeepers as recorded in the annual form 5500 filing.

“In reality, this total compensation number includes significant transaction costs that do not constitute plan recordkeeping fees, and they do not reflect revenue-sharing amounts that may be rebated to the plan,” he says. “Plaintiff lawyers use these inflated numbers to mislead the courts into believing the plan fiduciaries are somehow guilty of gross fiduciary malpractice. By doing so, they are breaching a lawyer’s professional duty of candor to inform the court that every participant has received the correct and accurate recordkeeping fees from a Department of Labor mandated participant fee disclosure four times a year. Plaintiff law firms and their clients have the correct numbers available to them, but nonetheless they continue to file misleading lawsuits.”

As an example, he points to the case filed by Capozzi Adler on May 2 against O’Reilly Automotive Inc.  The lawsuit from former O’Reilly employees alleges that the recordkeeping fee was $49.55 per participant in the last year listed in the lawsuit.

“That number is wrong,” Aronowitz says. “Plaintiffs ignored the truthful data from their participant fee disclosure that the actual recordkeeping fee was a very reasonable $31 per participant. Why does this keep happening over and over? Because no court to date has required accurate pleading of plan fees based on DOL-mandated disclosures. There has been no ramification for this shameful business practice, and plaintiff firms like Capozzi Adler will keep doing it until the courts or the Department of Labor put an end to this nonsense.”

Aronowitz says the current state of affairs is not solely to blame on one law firm, or on the handful of firms that file nearly all ERISA excessive fee cases in a given year. Rather, it is a systematic issue that also involves the behavior of fiduciary defendants and their attorneys.

“This may not be a popular opinion, but I also feel the defense lawyers are, to some extent, responsible for the pace of cases, and this is because they seem to file a motion to dismiss every single time a client faces an excessive fee challenge,” Aronowitz observes. “That is actually not helpful for the overall health of the DC plan system, because they are seemingly taking the position that every single excessive fee case ever filed is illegitimate. Of course, that is not true. Some cases have obvious merit.”

This blanket approach, he argues, sends the wrong signal to the judges who have to rule on these cases and decide whether discovery is appropriate.

“We have to be honest and see that, in the case of Northwestern University, for example, the fees being charged were in fact relatively high,” Aronowitz says. “They were using multiple recordkeepers with uncapped fees, and the court took notice of this.”

Simply put, when every case is suggested to be spurious, it adds to the hesitancy of judges to dismiss plaintiffs’ claims.

“Look, I get it. Just like the courts, the lawyers also handle these cases one at a time, and they are going to defend their clients aggressively, because that is just what they do,” Aronowitz says. “My take is that we need to have more perspective. I would have settled the Northwestern case, not taken it to the Supreme Court, but I would fight a case like the one targeting Kroger.”

Aronowitz says the current environment is unsustainable from the fiduciary insurer’s perspective, such that it could become nearly impossible for well-known plan sponsors to adequately insure their fiduciary liabilities at an affordable rate. In fact, the fiduciary insurance model has already changed, he says, and the vast majority of policies are now written with multi-million-dollar retention amounts, which effectively function as sizable deductibles for the insured plan sponsors.

“There was a time when fiduciary policies sometimes had a $0 retention or a very modest deductible,” Aronowitz says. “Those days are long gone. Back in 2016, a defendant like Northwestern University would have paid only the first $50,000 or so of their defense, and then the insurance firm would pay everything thereafter, up to the policy limit. Now, the retention figure for a large university seeking to acquire fiduciary insurance may be upwards of $5 million or $10 million. Up to that point, the insurer doesn’t pay anything.”

Aronowitz says this change may be the one thing that can slow down the rate of settlements, in that plan sponsors would have to use their own coffers to pay settlements. This fact may, in turn, lead to more cases being litigated fully and ruled on in a way that resolves some of the surrounding issues. But that hope is cool comfort to the plan sponsors facing suit now, or to those who will in the future.

“Right now, these factors are an existential risk to the fiduciary insurance business as it exists today,” Aronowitz concludes. “We could easily reach a point where big universities and big hospital systems, and other types of employers that tend to be targeted with these suits, could find it impossible to afford adequate insurance.”

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