ESG investing rules provide early test of US agency’s power limits

A challenge to a Biden administration rule allowing employee retirement plans to invest in socially-sensitive retirement plans will be an early test of how courts will analyze federal regulations after the U.S. Supreme Court ruled they no longer have to rely on the expertise of the agencies that issued them.

The New Orleans-based U.S. Court of Appeals for the Fifth Circuit will hear arguments Tuesday in a lawsuit by 25 Republican-majority states challenging a U.S. Department of Labor rule that allows 401(k) and other plans to consider environmental, social and governance (ESG) factors as a “determinative factor” in investment decisions.

U.S. District Judge Matthew Kacsmaryk in Amarillo, Texas, declined last year to block the 2022 rule, citing a 40-year-old doctrine known as the Chevron compliance rule, named for a 1984 Supreme Court ruling that required courts to uphold reasonable interpretations of agency-enforced regulations.

Kacsmaryk, appointed by Republican former President Donald Trump, is the only active judge in Amarillo, and his court has become a favorite venue for conservative litigants suing to block Biden administration policies. But in dissent over the ESG rule, the judge said he is obligated to apply Chevron unless the Supreme Court strikes it down.

The high court did just that in its June ruling in Loper Bright Enterprises v. Raimondo, saying judges should instead use their independent judgment when evaluating agency rules.

The decision is expected to have a broad impact on the government’s ability to pass new regulations, such as environmental, securities and labor laws, and is part of a broader effort by conservative groups to curtail the powers of what they call the “administrative state.”

And the ESG rulemaking case will give the Fifth Circuit Court of Appeals a chance to reexamine the Supreme Court’s directive that courts exercise independent judgment and consider what framework the appellate court will apply to cases challenging the agency’s rules in the future.

“The trial court expressly citing Chevron on the issue of ESG compliance … puts this case on track to becoming an early sign of how courts will handle the backlog of cases,” said Julie Stapel, a Chicago-based attorney at Morgan Lewis & Bockius, who represents employers.

Lawyers for the states that sued over the ESG regulations and for the U.S. Department of Justice, which is defending the regulations, did not respond to requests for comment.

In a June 28 letter to the 5th Circuit, the states said the Supreme Court’s decision earlier that day strengthened their claim. Citing the ruling, they said courts should consider deferring the case to the agency only if the regulations are adopted shortly after the laws they interpret and remain consistent over time.

The lawyers wrote that under that standard, the Labor Department should not be held to account because its position on whether a 1974 law governing employee benefit plans permits ESG investing has changed multiple times.

The Justice Department, in response to court filings with the states, said it did not cite Chevron in its opinions and that a panel of the 5th Circuit Court of Appeals should use independent judgment to determine whether the rule is valid.

12 trillion dollars

A key issue in this case is whether the 1974 Employee Retirement Income Security Act allows retirement plans to consider non-cash factors when making investment decisions. The Labor Department, in adopting the rule, said the statute does not address this issue and that considering ESG issues is permissible as long as financial factors are top of mind.

The rule has been sharply criticized by conservatives who say weaving a political agenda into investment decisions threatens workers’ retirement savings. The rule covers plans that collectively invest $12 trillion on behalf of more than 150 million workers and retirees.

The Fifth Circuit is widely considered the most conservative U.S. appellate court and has largely abandoned the Chevron doctrine in recent years while blocking a raft of Biden administration regulations. All three judges on Tuesday’s panel were appointed by Republican presidents.

The fact that the ESG provision will be considered by the 5th Circuit Court of Appeals could lessen the impact of the Supreme Court ruling on the case, said Katherine Kohn, a lawyer with the Washington firm Thompson Hine who advises companies on employee benefits.

“If the Fifth Circuit is inclined to overturn this rule, there is probably a path forward to do so, even if we continue to live under Chevron,” she said, “although the Loper Bright ruling certainly makes it easier for the Fifth Circuit to side with the (states).”

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