Authors’ Synopsis: Recent headlines criticizing investment strategies incorporating environmental, social, and governance (“ESG”) consid-erations have unsettled many fiduciaries. But are these criticisms well-founded and do they apply to all forms of ESG-related investing? Moreover, do the duties of loyalty and care prohibit a fiduciary’s use of certain forms of ESG-related investing and, if so, how should a fiduciary apply these restrictions when making an investment decision?
This Article argues that fiduciaries should engage with ESG-related strategies in the same way that they might select a non-ESG approach: by thoughtfully analyzing stated objectives and underlying processes. In arriving at this conclusion, this Article explores the limits of the duty of loyalty’s “no further inquiry rule” based on the rule’s traditional focus and application and questions conventional wisdom regarding the impacts of ESG-related investing on a portfolio’s return and volatility. Additionally, this Article discusses the ways in which a fiduciary or the creators of a trust or charitable organization may bolster and broaden the use of ESG-related investing through express authorization and/or beneficiary involvement.**
Your Uncle Leonard, a world-renowned physician and explorer, recently passed away and named you as trustee of the trust for his children. While you did not spend much time with your uncle due to his work-related travel, you’re fond of his children and agreed to administer the trust. As you decide how to invest the trust’s assets, you find yourself drawn to an “Enterprise Fund” that seeks to generate index-like returns while supporting positive social and environmental goals worldwide. The strategy’s focus on companies expanding health care access to under-served communities seems particularly appealing. Promoting health care in under-resourced populations feels like something Uncle Leonard would applaud, though he never discussed his investing preferences with you. In fact, he typically responded to questions about the stock market by saying, “I’m a doctor, not a financial advisor!”
Can you invest in a fund that seeks both financial and nonfinancial goals without violating your fiduciary duties? You know you’re required to invest the trust funds solely in the interests of the beneficiaries and with reasonable care in the context of the trust’s purposes and terms. You’ll also be held personally liable for any damages from a breach of trust. Unfortunately, the trust agreement does not overtly address the issue, which adds to your uncertainty.
This Article addresses these concerns and provides a road map for fiduciaries looking to evaluate and engage with investment strategies that incorporate environmental, social, and governance (“ESG”) considera-tions. Part I summarizes the origins and evolution of the ESG investing universe, including an in-depth description of the following:
(1) ESG integration (a practice that integrates ESG considerations alongside traditional financial metrics to achieve a greater risk-adjusted return), and
(2) ESG-focused strategies (those that incorporate ESG considera-tions into both their mandates and implementation to support financial and nonfinancial goals).
Part II describes a fiduciary’s duty of loyalty and how and when fiduciaries may consider an investment’s collateral impacts—including ESG investing goals—while satisfying this duty. Part III describes a fiduciary’s duty of care and how it informs the evaluation and selection of an investment strategy. Finally, Part IV suggests ways for a trust’s interested parties or a charitable nonprofit’s decision-makers to bolster and broaden fiduciary use of ESG investing strategies through express author-ization in an applicable governing document or beneficiary involvement.
Before we begin, we must first establish certain parameters. Commentators have long discussed the pros and cons of active versus passive management, and the market currently offers both forms of ESG-related investing. As a summary of this debate exceeds the reasonable scope of this piece, we will limit our focus to ESG-related investing in the world of active management. More specifically, we will address ESG-related investing only in the context of public equities and fixed income. While many of the principles discussed herein apply to ESG-related investing in other asset classes, these strategies tend to take too idiosyn-cratic of an approach to risk and return for this Article to sufficiently address. Lastly, we will confine our conversation to the fiduciary duties of loyalty and care. However, we acknowledge that other duties—including that of impartiality—may also play a role in a fiduciary’s analysis of ESG-related investing.
The responsible investing (“RI”) movement, which includes modern-day ESG investing, originated with faith-based investing by groups such as Muslims, Quakers, and Methodists. While Muslims sought to invest in compliance with Islamic law, Methodists and Quakers avoided businesses that dealt in alcohol, tobacco, gambling, and the slave trade. In the 1970s, RI gained a secular edge as investors sought to rule out companies contrib-uting to the Vietnam War. This included Pax World’s launch of the first sustainable mutual fund for religious investors looking to avoid Agent Orange supply chains. The 1980s saw RI further broaden its scope as the anti-apartheid movement led some funds to exclude companies doing business in South Africa as part of a larger call for divestiture.
These early RI efforts relied solely on negative and positive screening to support their investment mandates. In the context of RI, negative screening focuses on excluding objectionable assets or industries, while positive screening focuses on the inclusion of companies achieving invest-ors’ social or environmental goals. Although screening is common-place in the investment world, early RI strategies were unique in employing screens for nonfinancial purposes and without regard to the screen’s impact on return and volatility. Thus, investors in such strategies had to subordinate their financial goals to the strategy’s social or environmental objectives, making the funds “concessionary” in nature.
In contrast to the limited offerings of the past, modern ESG investors face an ever-expanding array of investment options aimed at key themes.
For those simply seeking an improved risk-adjusted return, ESG integration uses financially material ESG considerations to better assess a security’s future performance and highlight market inefficiencies. ESG-focused strategies, on the other hand, offer investors a means of promoting social and/or environmental change while simultaneously pursuing finan-cial return. In addition to this diversity of investment mandates, the means of implementing an ESG integration or ESG-focused strategy also vary across managers. With so many options, investors may feel overwhelmed and unsure how to evaluate a potential strategy’s objectives and perform-ance. To shed some light on this topic, let’s dig a little deeper into ESG integration and ESG-focused strategies.
ESG integration refers to a manager’s use of material ESG considerations to better gauge an investment’s future financial perform-ance and thus enhance risk-adjusted returns. Put more simply, a manager employing ESG integration evaluates the ways in which a company engages with an ESG issue material to the company’s processes or prod-ucts. If the company fails to appropriately address the issue, that oversight may highlight a future financial risk (for example, a fine or lawsuit). If the company outperforms its peers in managing the issue, it may be at a financial advantage (for example, if the company invests in new technol-ogy or industry-leading practices). Importantly, the manager evaluates a company’s ESG-related performance alongside and in conjunction with more traditional financial metrics to determine whether including a specific security will bolster the overall portfolio’s financial performance. Unlike earlier RI strategies, ESG integration does not label investments in a binary manner as “good” or “bad”—or prohibit owner-ship of companies in any industry. The goal is not exclusion based on a nonfinancial motive but better-informed, financial decision-making.
For example, an active manager creating a portfolio focused on the health care industry may begin with a broad potential investment pool based on sector, revenue, and market capitalization. The manager then will narrow this pool through a mix of quantitative analysis—mathematically ranking stocks based on objective financial metrics—and qualitative analysis, assessing the strength of subjective factors like a company’s competitive advantage, management strength, and financial health.
As part of this assessment process, a manager engaging in ESG integration will identify material ESG issues for each security under consideration. In the health care industry example, such issues might include product safety standards, access to health care, and privacy protocols, among others. The manager then will assess how the company addresses the ESG issue and whether such performance impacts the company’s current value. For instance, assume that a health care facility institutes aggressive productivity quotas that result in greater earnings for the company but also lead to haphazard data management practices. That is, employees do not take the time to implement data protection measures because they are under severe, quota-driven time constraints. Traditional investors might value the company based on the promise of increased earnings and positive future performance. However, after analyzing the ESG considerations underpinning the earnings increase, an ESG-aware manager might discount the increased profits. For such a manager, the corresponding erosion of data protection standards and the financial impact of a potential data breach’s consequent legal costs and damage to patient relationships highlight an increased risk that detracts from the company’s present earnings. In this way, ESG integration allows portfolio managers to be more forward looking, rather than relying solely on historical performance.
Additionally, material ESG considerations may signal opportunities for active managers to exploit market inefficiencies, as such consider-ations may be especially vulnerable to the broader market’s mispricing. For example, recent research indicates that a company’s history of ESG risk incidents correlates with a higher rate of future incidents and under-performance in terms of profitability and risk-adjusted returns (meaning the market underappreciated the company’s ESG risks). Indeed, the study reported that a portfolio with a high rate of adverse ESG incidents generated anomalous stock returns of -3.5% per year in the United States and -2.5% per year in Europe, even when controlling for risk factors, industries, and firm characteristics. The report suggests that traditional investors fail to accurately assess a risk incident’s long-term implications for a company’s value—due in large part to inconsistency in ESG measurements, weighting, and reporting; the long-term nature of ESG value implications; and corporate “greenwashing.” But this was not true for all investors. Rather, investors who focused on ESG issues (that is, investors who are more likely to incorporate ESG information that is material but hard to quantify) built portfolios with lower risk incident exposure and better performance than their peers. Thus, a sophisticated approach to ESG considerations allowed certain investors to capitalize on the current ambiguity surrounding the relationship between ESG issues and financial performance.
While ESG integration may lead to greater returns over time, its effectiveness depends heavily on the selection of material ESG issues. Here, managers differ in their approach, with varying levels of success. Some managers rely on one or more third-party ESG ratings to rank a company’s ESG performance in relation to its peers. Such rating agencies collect data from various sources—including annual reports, websites, and direct contact with companies on ESG-related issues—and then assign a weight to this data based on its materiality to the company’s core purpose. Returning to our previous example, a rating agency would likely give a health care provider’s environmental attributes (for example, its waste management protocols) less weight than its employee and patient safety standards.
However, third-party ratings suffer from certain limitations. They offer a static look at a company’s ESG-related attributes based on current conditions and the recent past. Plus, different agencies frequently dis-agree on a single company’s material ESG issues and rating. To address these concerns (and, in some cases, in place of using third-party ratings), managers may engage in fundamental research with respect to a material ESG issue. This allows the manager to project how the ESG consideration might evolve in the future (for example, a company’s cutting-edge tech-nology practices may provide less of a financial benefit as they become industry standard).
Additionally, hands-on research allows a manager to evaluate whether attributes underlying a company’s ESG score are material to the company’s financial performance. For example, a manager may down-grade an ESG score that initially benefited from the adoption of a diversity and inclusion policy if the company fails to appropriately implement the policy, thereby undermining its impact on employee recruitment and retention.
While managers utilize ESG integration as a security selection tool without regard to a strategy’s underlying mandate (that is, the overall strategy does not need to pursue a social or environmental objective), an ESG-focused strategy pursues financial and ESG-related collateral benefits. This does not mean that the strategy necessarily elevates its ESG-related mandate above its financial goals, as some commentators suggest. Indeed, we will focus exclusively on strategies designed to deliver financial performance comparable to their non-ESG peers (that is, nonconcessionary strategies) while supporting an additional ESG-related objective.
A manager building an ESG-focused portfolio will begin by selecting an initial pool of investment opportunities based on an ESG-related theme or objective. For example, a portfolio’s underlying strategy may revolve around industries impacted by one or more of the United Nations Sustainable Development Goals (“SDGs”). After identifying the target-ed industries, the manager can select companies within each industry that produce profitable products (for example, sources of renewable energy) through a combination of quantitative and qualitative analyses. In this way, the manager creates a potential investment pool connected to the ESG-related goal and capable of producing a desired level of return.
Fundamental research can then help identify companies within the narrowed opportunity set that are most likely to deliver the desired ESG-related impact without sacrificing return or increasing risk. For instance, our research shows that changes in a company’s ESG rating over time (sometimes referred to as its “ESG momentum”) can provide insight into the company’s future financial performance. In one study, we found that the average forward return for stocks with positive ESG momentum (that is, an ESG-rating upgrade from the same rating provider) generally exceeded global equity peers on a relative basis (as measured by the MSCI ACWI Index). Meanwhile, the performance of stocks that had been downgraded lagged.
To put this in context, let’s return to our previous example of a strategy favoring industries impacted by one or more SDGs. Having identified certain target industries and profitable companies within them, a manager may then evaluate the ESG momentum of these potential investments with respect to a relevant SDG. In other words, how do the company’s efforts to improve its material ESG processes support the SDG? While exploring this question, the manager may uncover companies that are better posi-tioned to support the strategy’s desired social or environmental objective and generate a superior return (sometimes referred to as a “double bottom line”).
Commentators have sometimes painted the additional restrictions applied by ESG-focused strategies in a negative light. However, such strat-egies may benefit from a narrower focus in the same manner as non-ESG active counterparts. Consider a climate-focused approach that devotes attention to areas indirectly impacted by the transition away from fossil fuels (for example, utility companies that will benefit from infrastructure spending to support a greater reliance on electricity). The manager’s in-depth understanding of energy consumption’s evolution will provide insight into certain industries overlooked by an investor relying on historical data—allowing the manager to create a more focused, leaner initial investment pool. With a smaller pool of candidates, the manager will be well positioned to apply fundamental research to the remaining securities to unearth opportunities that might otherwise be missed.
Additionally, managers can select and implement ESG-related themes in a manner that limits impact on portfolio diversification and volatility. In the early days of RI, commentators raised concerns that the application of positive or negative ESG-related screens would decrease or eliminate exposure to certain market industries or sectors to a portfolio’s disadvan-tage when compared to the stock market as a whole. For example, if an excluded industry or sector experienced a period of outperformance, the portfolio could struggle when compared with nonexclusionary peers. Alternatively, the portfolio might suffer if the exclusion resulted in a heavier reliance on an industry or sector that underperformed. However, our research demonstrates that such negative impacts are far from certain.
For instance, a strategy seeking to identify SDGs-aligned investments may still include a wide range of industries and countries.
This strategy allows managers implementing the ESG-related theme to choose assets that will react differently to certain market conditions (that is, diversify the portfolio), thereby limiting the downside of market volatility while still supporting the strategy’s ESG-related objective.
Further, our research shows that limiting the investment universe through ESG-related screening may only modestly impact a portfolio’s total return. For example, we built seven different portfolios, applying a different ESG-related exclusion to the S&P 500 in each case. Upon tracking the portfolios over a ten-year period, we found that six out of the seven performed within 0.2% of the S&P 500—with three of the six portfolios outperforming the S&P 500 and one matching it.
Additionally, five of the seven portfolios produced annualized volatility equal to or less than the S&P 500 (the remaining portfolios showed an increase of 0.2% or less). Even more surprising, when we applied all seven exclusions to the same portfolio—thereby excluding one-third of the companies in the S&P 500—the portfolio bested the S&P 500 by more than 2% with one a 0.4% increase in volatility. Does this mean that exclusions ensure a better risk-adjusted return? Certainly not. Rather, our results demonstrate that an ESG-related exclusion on its own does not necessarily generate the decreased returns and spike in volatility previously suggested.
A portfolio manager may further reduce any potential impact from an ESG-related exclusion—whether positive or negative—by employing a materiality threshold. Returning to our previous example, if you were to apply a 5% revenue threshold to the nonenergy exclusions and focus the energy exclusion on the highest emitters in the potential investment pool, the resulting portfolio would exclude only 11% of the S&P 500, rather than 33%. Thus, a more nuanced approach to negative screening can weed out many objectionable investments without hindering a portfolio’s ability to track its designated index.
Nonetheless, our research shows that historically, ESG-focused strategies have a higher likelihood of tilting toward certain factors and sectors.
For example, these approaches may favor growth and quality factors (for example, profitability) rather than value (that is, cheapness). Additionally, they tend to tilt toward the technology and health care sectors, and away from financials and basic materials. Thus, a fiduciary considering an ESG-focused strategy will need to weigh how any existing tilt interacts with the rest of the fiduciary’s portfolio as well as the investing entity’s ultimate needs.
Additionally, we should note that ESG-focused investment strategies may not be appropriate for investors with shorter time horizons. The latent risks and returns that ESG analysis reveals may be likelier to unfold slowly as failures or inefficiencies in a sector or industry become clearer, and the market reacts to them over time. For this reason, ESG-focused investing—much like equity investing in general—is typically regarded as a more suitable approach for long-term investors.
Lastly, in the same manner that an investment strategy cannot guarantee desired financial performance, ESG-focused strategies may fall short of their ESG-related objectives. In fact, the more ill-defined a social or environmental goal, the harder it maybe to measure a strategy’s impact and nonfinancial performance. For this reason, fiduciaries should seek out ESG-focused strategies with clear and measurable nonfinancial objectives.
Thus far, large-scale studies of ESG’s impact on financial performance have produced conflicting results. Take two recent meta-studies exploring the connection between ESG and financial performance based on research papers published between 2015-2020. In one meta-study, researchers found that 59% of investment studies focused on risk-adjusted attributes showed a positive or neutral correlation between ESG and financial performance when compared to conventional strategies, while 14% showed a negative correlation. In a meta-study released a year later, these same researchers noted that twelve of the thirteen meta-analyses reviewed found a positive association between aspects of sustainability and company-level financial performance. However, when averaged across strategies in aggregate, returns from ESG investing appeared no better than those from conventional investment strategies. In other words, the anecdotal evidence from active managers about the benefits of ESG bore out at the individual company level but did not translate into overall portfolio performance across managers. In explaining the conflicting results in both studies, the research team noted struggles with inconsistencies in terminology, data reporting, and measures of materiality, along with confusion and conflation of various ESG invest-ment strategies. At a minimum, large-scale studies of ESG’s impact on financial performance seem to suffer from hurdles in aggregating and standardizing data and may lag behind the diverse offerings of a rapidly developing industry.
The rating agencies many investors rely on to quantify ESG data face similar struggles. ESG rating agencies frequently conflict with respect to the factors used, and the weight assigned to them. In addition, efforts by rating agencies to quantify material ESG attributes may unintentionally overlap with more traditional investment metrics. Consider the researchers at Scientific Beta who reconstructed long-short ESG-related strategies from prior studies. They found that positive performance and risk protect-ion previously attributed to the use of ESG ratings disappeared when they accounted for exposure to standard factors—especially quality.
And yet, we cannot ignore that existing research shows a distinct connection between ESG considerations and company-level performance. Large-scale research studies’ inability to demonstrate this connection at the portfolio level does not negate the anecdotal evidence of individual managers utilizing ESG considerations to deliver on the promised double bottom line. Instead, the disconnect between larger studies and individual case studies highlights what has always been true for active investing—research, skill, and a repeatable process remain key to a strategy’s success. Active management strategies have long been impacted by the skill and approach of the manager at the helm. Not surprisingly, ESG-related strategies are no different.
Now, let’s discuss the duty of loyalty as it applies to fiduciaries managing trusts, private retirement plans, and charitable nonprofits.
Often called a trustee’s most fundamental duty, the duty of loyalty can be summarized as a directive to act solely in the interests of the trust’s beneficiaries without interference from the trustee’s own interests or those of third parties, unless the trust terms provide otherwise. This duty arose under common law to prevent a trustee from favoring a conflicting interest—whether consciously or unconsciously—over that of the bene-ficiaries. Indeed, concerns about a trustee’s ability to navigate competing interests in the same transaction were so great that it led to the creation of a “no-further-inquiry rule.” This rule renders certain transactions voidable under the duty of loyalty based on the parties involved, rather than their underlying motives or impacts. More specifically, the rule permits a beneficiary to void any transaction involving (1) a trustee’s self-dealing or (2) an existing or potential conflict between the trustee’s fiduciary duties and personal interests, regardless of whether the transaction benefits the beneficiary.
On its face, this duty seems easy to understand and apply in the context of investing trust assets. A trustee may not elevate the trustee’s personal beliefs or goals above the beneficiaries’ interests. For example, the trustee may not invest in a concessionary strategy that sacrifices return to advance the interests of nonbeneficiaries. But what if you are deciding between two investment strategies bearing similar risk and return profiles and one of them supports an additional social or environmental objective? Could you consider the collateral impacts of each strategy under these circumstances? You are not sacrificing return or increasing risk and thus elevating the social or environmental objective above the beneficiaries’ interests. But would this qualify as a conflict of interest to which the no-further-inquiry rule would apply, thereby rendering the strategy’s financial impacts irrelevant?
To answer these questions, let’s examine the duty of loyalty’s application and limitations under both common and statutory law, starting with the former. As noted above, current articulations of the common law duty of loyalty apply the no-further-inquiry rule to cases of self-dealing or a conflict of interest—not all transactions. Additionally, common law acknowledges certain exceptional situations where, despite the presence of self-dealing or a conflict of interest, considerations of practicality and reduced risk require an easing of the no-further-inquiry rule. In situations where the duty of loyalty does not impose the no-further-inquiry rule, a trustee must continue to “act fairly, in good faith, and in the interest of the beneficiaries.”
What then constitutes an act of self-dealing or a conflict of interest to which the duty of loyalty applies the no-further-inquiry rule? Let’s begin by defining self-dealing. Common law describes self-dealing as the trustee’s engagement on behalf of the trust with the trustee, a third party acting as a conduit for the trustee, or an entity in which the trustee owns a substantial financial interest, among other examples. Interestingly, authorities conflict on whether an action motivated by the beneficiaries’ best interests—but which produces an “incidental benefit” to the trustee—constitutes self-dealing for purposes of the no-further-inquiry rule.
Next, let’s consider what constitutes a conflict of interest. Common law defines a conflict of interest as a situation in which the trustee interacts on behalf of the trust with a person or entity closely related to or associated with the trustee (“related parties”). For example, the duty of loyalty prohibits transactions between the trustee and the trustee’s spouse, parents, descendants, personal agent, or attorney. Common law does not apply the no-further-inquiry rule to transactions involving a trustee’s more remote relatives or personal or business acquaintances. In those situations, the trustee is not presumed to have a conflict of interest and a beneficiary must prove a breach of trust by demonstrating that third party interests improperly influenced the trustee in a manner disadvantageous to the beneficiaries’ interests.
To put this in a familiar investment context, imagine that the no-further-inquiry rule functions as a negative screen for a trustee’s possible investment opportunities. In other words, the trustee eliminates those opportunities that involve self-dealing or a conflict of interest from consideration up front. The trustee is then responsible for analyzing the remaining strategies to determine which meet the needs of the bene-ficiaries. As part of this analysis, the trustee may consider a strategy’s collateral impacts to decide among approaches with comparable financial returns.
Moving on to statutory law, the Uniform Trust Code (the “UTC”) provides the duty of loyalty’s most commonly codified form. The UTC adopts the general standard that a trustee must act in the sole interests of the beneficiaries and applies the no-further-inquiry rule to self-dealing in the same manner as common law. However, the UTC deviates from common law in applying the duty of loyalty to conflicts of interests, despite identifying many of the same related parties as creating the poten-tial for conflict. More specifically, the UTC provides that a trustee’s transactions with related parties are voidable only if affected by a conflict of interest. This means the trustee may defend an action by showing that, even if a conflict existed, it did not impact the transaction. Thus, like those situations where the common law duty of loyalty applies but the no-further-inquiry rule does not, a trustee may defend an action with related parties by establishing the transaction’s fairness and similarity to trans-actions made with an independent party.
Now, let’s return to our original example of a trustee deciding between two investment strategies with similar financial profiles but dissimilar collateral impacts. Assuming the trustee does not profit from either strategy directly or indirectly, the no-further-inquiry rule should not arise from self-dealing. Additionally, assuming each strategy’s collateral impacts affect strangers (as would most often be the case with a larger social or environmental objective), this situation does not constitute a conflict of interest as defined under common or statutory law. This strategy selection then falls outside the reach of the no-further-inquiry rule—leaving the trustee with a defensible choice involving consideration of collateral impacts by showing that the selected strategy supports the beneficiaries’ financial interests in the same approximate manner as other alternatives.
While case law has yet to address this same scenario in the larger context of ESG-related investing, courts have previously interpreted the duty of loyalty (as explained above) in reviewing a fiduciary’s decision to sell or otherwise avoid investments due to ESG considerations. For instance, in Board of Trustees of the Employees’ Retirement System v. Mayor of Baltimore City, the Maryland Court of Appeals upheld city ordinances requiring city pension funds to divest from companies doing business in South Africa as part of an anti-apartheid movement—despite such ordinances’ indirect requirement that the fund trustees consider the interests of impacted South Africans. In doing so, the Court of Appeals noted that, while the common law duty of loyalty restricts a trustee from furthering a third party’s interest at the expense of the beneficiaries’ interests, it does not strictly prohibit a trustee from considering the social consequences of investment decisions when the costs of such consid-eration are negligible. Put more simply, the trustees’ consideration of strangers’ interests did not trigger a violation of the duty of loyalty where such consideration did not result in an unfair transaction.
Moving to private retirement plans, the Employee Retirement Income Security Act of 1974 (“ERISA”) requires that plan administrators serve as fiduciaries subject to a duty of loyalty like that imposed under common law. More specifically, these fiduciaries must administer the plan (i) solely in the interest of the plan’s participants and beneficiaries, and (ii) for the exclusive purpose of providing benefits to such individuals, while defray-ing reasonable administrative expenses. However, unlike the fiduciary duties imposed under a trust, a plan may not modify an administrator’s duty of loyalty.
As ERISA’s duty of loyalty stems from the related common law duty, the above analysis suggests that ERISA’s references to actions taken “solely in the interest of” and for the “exclusive purpose of providing benefits to” plan participants and beneficiaries should not broadly prohibit consideration of an investment strategy’s collateral impacts in the absence of self-dealing or a conflict of interest. Indeed, courts have previously upheld plan investments that produce an incidental benefit to a third party, provided that such benefit does not come at the expense of plan partic-ipants and beneficiaries. For example, in Donovan v. Walton, the court held that the pension plan trustees did not violate ERISA’s exclusive purpose standard by financing construction of an office building on the pension trust fund’s property and leasing the building to one of the plan’s participating employee organizations. In reaching this conclusion, the court noted that the arrangement benefited both parties and the exclusive purpose standard “does not prohibit a party other than a plan’s participants and beneficiaries from benefiting in some measure from a prudent transaction with the plan.”
Additionally, the Department of Labor (the “DOL”) has described ERISA’s duty of loyalty as a bar against harm to the financial interests of the plan’s participants and beneficiaries. In rules issued in late 2020 and 2021, the DOL addressed the elements of the duty of loyalty by stating that a plan administrator “may not subordinate the interests of the partic-ipants and beneficiaries in their retirement income or financial benefits under the plan to other objectives, and may not sacrifice investment return or take on additional investment risk” as compared to reasonably available alternatives. Thus, ERISA’s duty of loyalty prohibits an administrator from prioritizing the interests of third parties over those of the plan participants and beneficiaries but does not similarly prohibit consideration of an investment’s collateral impacts. In fact, both rules expressly authorize plan administrators to consider collateral benefits in deciding between two comparable investment strategies.
The duty of loyalty applicable to individuals exercising authority over a charitable entity varies depending on its structure. For a charitable trust, the duty of loyalty requires that the trustee administer the trust solely to further its charitable purpose. The trust terms will define this purpose, including its scope.
An even more relaxed duty of loyalty applies to charitable nonprofits structured as corporations, associations, or limited liability companies. More specifically, such entities are subject to a “best interest” standard that requires fiduciaries to act in good faith, with reasonable care, and in the best interests of the entity’s charitable purpose based on all relevant circumstances. In effect, this standard matches the duty of loyalty as applied to a trustee’s actions in the absence of the no-further-inquiry rule.
When applied appropriately, ESG integration satisfies the duty of loyalty on its face by relying on ESG considerations to predict an invest-ment’s future financial performance—rather than to inform a strategy’s overall objective or to promote the interests of the fiduciary or third parties. Additionally, it should not trigger an application of the no-further-inquiry rule in that (i) it does not financially benefit the fiduciary or a related party and (ii) it does not advance the interests of third parties at the expense of the relevant beneficiaries’ interests. In fact, use of an ESG integration strategy may lead to a more thorough evaluation of a potential investment’s suitability to the beneficiaries’ needs.
However, we should reiterate that the foregoing analysis depends upon proper implementation. A manager must analyze ESG considerations for their ability to predict potential risks and returns. Additionally, a fiduciary should examine how a manager quantifies a company’s ESG performance and whether such performance is indeed material to the company’s long-term value. For example, a fiduciary may ask whether the manager relies on third-party ESG ratings, and if so, how the manager utilizes fund-amental research to contextualize ESG considerations.
Assuming an ESG-focused strategy does not financially benefit the fiduciary or a related party, the fiduciary of a trust, private retirement plan, or charitable nonprofit may consider use of an ESG-focused strategy. As a first step in analyzing such strategy, the fiduciary must determine whether the ESG-focused strategy serves the beneficiaries’ interests in the same manner as available alternatives—both with respect to return and cost and the beneficiaries’ specific needs (for example, capital appre-ciation versus income production). If a fiduciary of a noncharitable trust or a private retirement plan determines that an ESG-focused strategy is designed to generate comparable returns and costs, the fiduciary may then consider collateral impacts to distinguish between investment options.
As a threshold issue and a point of distinction between charitable and noncharitable entities, the duty of loyalty would likely restrict a fiduciary of a noncharitable trust or private retirement plan from investing in a concessionary ESG-focused strategy. That is, the fiduciary’s use of such a strategy would necessarily violate the duty of loyalty by subordinating the beneficiaries’ financial interests to the strategy’s nonfinancial objectives. The fiduciary of a charitable nonprofit, on the other hand, is bound by the duty of loyalty to serve the entity’s charitable purpose. This means the fiduciary of a charity may utilize a concessionary strategy if the investment’s nonfinancial value to the charity’s mission outweighs the investment’s potential financial consequences.
The common law duty of care applies in approximately the same manner to trusts, private retirement plans, and charitable nonprofits, although a trust’s terms may modify this duty. More specifically, it imposes a “prudent investor rule” under which a fiduciary must invest and manage an overall portfolio as a prudent investor by considering the investing entity’s “purposes, terms, distribution requirements, and other circumstances.” This includes adopting appropriate risk and return objectives to meet the entity’s need for liquidity, income, and capital appreciation in light of all relevant distribution time horizons.
A charitable nonprofit’s investment analysis may be even more nuanced, in that the prudent investor rule allows such institutions to give weight to an investment’s support of the nonprofit’s charitable purpose in addition to its financial return. Additionally, the rule requires a fiduciary to diversify the investing entity’s overall portfolio, unless the fiduciary determines that diversification does not serve the entity’s best interests due to special circumstances. Now, let’s take a closer look at the various components of the prudent investor rule.
First, it’s important to recognize that—in a break from earlier law—the prudent investor rule requires an investing fiduciary to evaluate individual investments in the context of the larger portfolio. This means that a fiduciary may select an investment with exposure to unique invest-ment factors or sectors, provided the fiduciary appropriately adjusts the strategy’s proportion relative to the remainder of the portfolio and invests such remainder to balance out any under- or over-exposure to certain market sectors, etc. For instance, our research indicates that limiting a more volatile position to 5-10% or less of the overall portfolio prevents any meaningful increase in such portfolio’s risk profile.
Speaking of risk, the prudent investor rule allows risk to play a more active role than previous iterations of the duty of care. Where prior law emphasized a fiduciary’s duty to preserve capital and generate consistent income—and labeled investments such as growth stocks and discounted bonds as speculative and improper—the prudent investor rule recognizes that compensated risk (that is, investments that provide greater return in exchange for increased risk) may benefit an overall portfolio. This holds especially true as one considers the impacts of inflation on traditionally less-risky investments (for example, treasury bonds) over time.
Lastly, the prudent investor rule requires diversification to reduce the impact of uncompensated risk (that is, risk that is not company-specific and thus unlikely to be compensated for with greater return). Put differ-ently, the prudent investor rule requires that a fiduciary invest in a range of investments likely to respond differently to the same market stimuli. For example, if certain investments in a portfolio suffer due to rising interest rates or supply chain concerns, the prudent investor rule requires that the portfolio include investments likely to react neutrally or even positively to such circumstances, thereby potentially reducing the greater portfolio’s volatility and buoying its overall performance.
As described above, the prudent investor rule focuses on the mechanics of the investment process, not its end result. Applicable law judges a fiduciary under this rule based on the fiduciary’s knowledge and conduct at the time of an investment decision. This is true both at the time of an initial investment and in conducting ongoing due diligence to ensure an existing strategy’s continuing suitability. Additionally, the duty does not bar the use of any particular approach, provided the fiduciary selects the investment after appropriate analysis. This allows a fiduciary to engage with new market products and strategies on a case-by-case basis. For example, asset-backed securities have a long history of being charac-terized as “imprudent” investments for fiduciaries. Rather than rely on such characterization, however, the duty of care encourages a fiduciary to determine whether asset-backed securities fit within the context of a particular investing entity’s portfolio based on opportunities, challenges, transaction costs, the value and seniority of the security, etc.
A fiduciary’s duty of care requires careful analysis of a potential investment’s risk and return profile in the context of an overall portfolio. In ESG integration, managers use material ESG considerations solely to provide insight into both risk and return and thus enhance the care of a fiduciary’s investment analysis. Additionally, ESG integration does not impose a narrowing of the investment universe that could hinder diversi- fication. As such, ESG integration should be compliant with the duty of care. Again, however, a fiduciary should conduct sufficient due diligence to ensure a manager’s ESG integration methods are properly implemented.
Under the duty of care, a fiduciary should analyze whether an ESG-focused strategy’s potential impact on the overall portfolio’s financial performance aligns with the relevant beneficiaries’ needs and goals. To do so, a fiduciary should look to the strategy’s historical performance compared to its selected benchmark and that of available alternatives. Further, the fiduciary should consider the role the investment plays in the overall portfolio when selecting available alternatives for comparison. To that end, if a strategy assumes increased risk but offers greater return potential, it should be compared to non-ESG peers designed to fulfill the same overall objective (that is, to elevate returns) and in the context of the portfolio’s risk-mitigating investments.
The fiduciary should also pay special attention to the limitations the strategy places on its potential investment pool. As explained above, relying on strategies that broadly limit exposure to large market sectors or industries may imprudently raise the portfolio’s level of risk and decrease returns, especially if a fiduciary imposes such exclusions without consid-ering their impact on diversification. However, the use of broad themes and materiality thresholds may allow for a fully diversified portfolio and thereby limit the restrictions’ negative impact.
Last but not least, a fiduciary must exercise ongoing due diligence and adjust the overall portfolio as needed to ensure that the strategies selected—including any ESG-focused strategy—continue to serve the beneficiaries’ financial interests in the context of their investment time horizon. This does not mean that any negative change in performance requires the abandonment of a particular strategy. Rather, meaningful change merely warrants a fresh analysis of the fiduciary’s expectations for the investment’s total return and how this return impacts the portfolio’s ability to meet the beneficiaries’ needs.
As previously discussed, the duties of loyalty and care do not prohibit fiduciaries from utilizing ESG-related strategies in many circumstances. However, as authorities conflict on this issue and little on-point case law exists, a fiduciary of a trust or charitable nonprofit may wish to gain additional assurance and protection from a governing instrument, or the beneficiaries themselves. Additionally, the creator of a trust or charitable nonprofit may wish to authorize ESG-related investments that do not carry the same risk and return profile as their non-ESG peers—an approach disallowed under a traditional fiduciary duty analysis. We now summarize these methods of bolstering and broadening fiduciary engagement with ESG-related investment strategies.
If a trust’s settlor would like to authorize or require the use of ESG-related investing, the settlor should consider memorializing this intent in the trust agreement. This may take the form of an introductory passage describing the settlor’s purposes in creating the trust and wishes for its future administration. Alternatively, the settlor could simply waive appli-cation of both the no-further-inquiry rule—leaving behind a best interest standard—and the prudent investor rule’s diversification requirement. The settlor may also expressly address and incorporate into the trust agreement an applicable “ESG-friendly” state statute that allows a trustee to consider the settlor’s or the beneficiaries’ social, environmental, and governance beliefs in making investment decisions. For example, Delaware Code section 3303 provides that the terms of a governing instrument may expand, eliminate, or otherwise modify in any way laws pertaining to “the manner in which a fiduciary should invest assets, including whether to engage in one or more sustainable or responsible investment strategies, in addition to, or in place of, other investment strategies, with or without regarding to investment performance.” Additionally, several states have explicitly authorized a trustee to consider the values and beliefs of the trust’s settlor and beneficiaries with respect to sustainable or responsible investing strategies in acting as a prudent investor. If a settlor wishes to rely on this type of statute, it may be beneficial to require under the trust agreement that the relevant parties provide the trustee with a written summary of their views on ESG investing at regular intervals.
However, interested parties should also consider the extent to which a settlor may curtail the beneficiaries’ interests and to whom the trustee should ultimately be beholden. Under common law, a settlor may only create a noncharitable trust for the benefit of beneficiaries who are identifi-able or ascertainable at the trust’s creation. If, however, a settlor gives a trustee the ability to invest in concessionary ESG-related strategies to the detriment of the trust’s identified beneficiaries, an argument may be made that the trust’s true beneficiaries are those third parties benefited by the authorized investment strategies, with such third parties being unidentifi-able and unascertainable. This would then void the trust. As such, a settlor wishing to authorize a trust’s ESG-related investments and the trustee of such trust should bear in mind that a trust’s terms can lessen the trustee’s fiduciary burden but not completely divorce the trustee’s investment decisions from the beneficiaries’ best interests.
A statement defining and informing a nonprofit’s charitable purpose should be included in the nonprofit’s governing document (for example, the trust agreement for a charitable trust or the bylaws for a corporation). For those wishing to authorize the use of ESG-related investing, creators of a charitable nonprofit should consider addressing the role of such investment strategies in the nonprofit’s mission statement. For example, a charitable nonprofit created to expand access to health care could describe in this statement an intent to support the mission both through investing its endowment in ESG-focused strategies that favor this theme and by using the return from such strategies to underwrite grants to additional health care providers.
In addition, those administering a charitable nonprofit may consider adopting an investment policy statement (an “IPS”) that defines the standard of conduct for fiduciaries and their agents authorized to manage or invest the nonprofit’s assets. The IPS should outline the benchmarks tied to performance standards as well as income production and/or capital appreciation goals to fund the charitable nonprofit’s operations over different time horizons. It could also include disclosure of financial interests among those responsible for the charitable nonprofit’s investment decisions to avoid self-dealing or a conflict of interest that could trigger the imposition of the no-further-inquiry rule in the context of a charitable trust.
But what of a trustee who is pushed by current beneficiaries to engage in an ESG integration or an ESG-focused investment approach but who is administering a trust that is silent with respect to ESG-related investing? The trustee may worry about future discord among the beneficiaries on this issue. In response to these concerns, a cautious trustee may wish to pursue beneficiary approval, either before or after investment.
A trustee may seek this approval through a prior written consent, under which the beneficiaries agree to release the trustee from liability for and ratify an investment. UTC section 1009 provides a safe harbor from a breach of trust claim if a trustee procures this type of consent, provided the trustee does not exercise undue influence in obtaining it and the beneficiary is aware of all relevant rights and material facts. Alter-natively, the trustee could consider seeking approval or ratification after the fact, when the trustee may present a history of positive performance for the beneficiaries’ consideration. UTC section 1005 provides that a beneficiary may not sue a trustee for breach of trust more than one year after receiving adequate disclosure of the facts underlying such claim and notice of such statute of limitations (commonly referred to as an “accounting”).
However, in each case, obtaining the consent or approval of all beneficiaries may be practically impossible, especially if the trust includes beneficiaries who are not yet born. As a work around, a trustee may seek to make use of the UTC’s representation statutes. More specifically, UTC sections 301–304 provide that—in the absence of a conflict of interest—the following individuals may represent and bind certain other beneficiaries:
To better understand how a conflict of interest might arise in this context, let us consider a case in which a trust currently provides for the parent of a minor child and will distribute property to such minor child in the future. Let’s further assume the parent wishes to authorize an invest-ment that might hinder return but would support a social cause dear to the parent’s heart. In such case, the investment might reduce the amount of trust property that will ultimately become available for the child’s use, thereby creating a conflict between the two beneficiaries. This conflict of interest would prohibit the parent from consenting to the investment on the child’s behalf, despite the parent’s role as the child’s natural guardian. Of course, if the parties anticipated a similar benefit to both the current and remainder beneficiaries (that is, if the strategy both supported the parent’s pet cause and delivered a strong total return), the parent would be able to represent and bind the minor child without conflict.
Moving away from the UTC’s potential solutions, the trustee could rely on contract law by providing the trust’s current beneficiaries with a description of the action taken and asking the beneficiaries to ratify such action, release the trustee from any related claim, and indemnify the trustee from any resulting harm or loss. Such a contract may even include a request for indemnification from claims brought against the trustee by beneficiaries who do not execute the agreement. As such, this strategy may provide the greatest coverage of all but would require the most beneficiary involvement to do so.
Perhaps most importantly, a trustee may seek ongoing beneficiary involvement to ensure that investment decisions made match the benefici-aries’ expectations and needs. For instance, a trustee may organize a yearly meeting with the beneficiaries. Additionally, the trustee may facilitate the development of a trust IPS to address, among other things: (i) the impact of the trust’s time horizon and distribution requirements on potential investments, (ii) the beneficiaries’ risk tolerance, (iii) desired monitoring and reporting requirements, (iv) guidelines regarding concentrated positions and diversification, (v) rebalancing requirements, and (vi) the role of ESG-related strategies in the trust’s overall portfolio.
The fiduciary of a trust, private retirement plan, or a charitable nonprofit need not shy away from ESG-related investment strategies for fear of a per se violation of the duties of loyalty and care. Rather, such fiduciary should engage with ESG-related strategies in the same way that the fiduciary might select a non-ESG approach: by thoughtfully analyzing the strategy’s stated objectives and underlying processes. A strategy that does not sacrifice the beneficiaries’ total return in the interest of other goals will likely satisfy the applicable duty of loyalty, and a strategy that functions as part of a larger portfolio with reasonable risk and return attributes will likely meet the applicable duty of care. Additionally, in the realm of private trusts and charitable nonprofits, governing documents that authorize ESG investing and open communication with and among the interested parties can make such analysis easier and less worrisome for fiduciaries. Ultimately, involvement of ESG considerations is not a silver bullet that will permit a fiduciary to ignore the quality of an investment approach—but neither is it an absolute indicator of fiduciary impropriety. Instead, ESG-related investing is an evolving tool at the disposal of fiduciaries that also reflects the interconnectedness of the world in which we all hope to live long and prosper.
