This article was co-authored by financial planning intern Mamie Odom.
Investing with good intentions can lead to bad outcomes. This is especially true for trustees and other fiduciaries who may wish to focus on environmental or socially conscious investment strategies that have become increasingly popular in recent years.
Whether you are setting up a trust or directing one as a trustee, you should be careful if you want to invest with environmental or social goals in mind. If you, or the trust’s beneficiaries, want to invest trust assets with a goal other than maximizing the financial benefits that accrue to beneficiaries, fiduciary standards may mean taking extra steps to avoid legal pitfalls.
Investing based on environmental, social, and governance criteria – often abbreviated as ESG investing – has become increasingly popular with investors in recent years. Yet, formally defining ESG remains difficult. The strategy’s broad and subjective focus has made it hard for analysts and regulators to evaluate ESG offerings. As James Mackintosh recently discussed in a series of articles for The Wall Street Journal, different ESG indexes often differ wildly in ranking a particular company. Mackintosh illustrates this inconsistency among ESG experts by noting that, depending on which analysts you ask, Shell is either one of the best or one of the worst energy firms by ESG standards.
Given the diversity of views on what an ESG strategy involves, it is not surprising that investors come to different conclusions about the strategy’s benefits and drawbacks. Many investors believe an ESG strategy is not only a way to pursue their ideals, but also an effective financial hedge against climate change and potential future political moves to limit society’s reliance on nonrenewable energy or practices that have grown socially unacceptable. Some investors, in turn, worry that ESG strategies are riddled with potential legal complications with an embedded opportunity cost of sacrificing long-term investment returns. These stances are not always mutually exclusive. Because the exact parameters of ESG investing remain unclear, implementing such a strategy on someone else’s behalf as a fiduciary can lead to regulatory and legal complications.
As an example of one such hazard, the Texas Center for Public Policy has highlighted that collective and coordinated divestment from fossil fuel companies may violate antitrust laws. Additionally, retirement plans invested with an exclusive ESG focus could breach the Employee Retirement Income Security Act of 1974, and potentially public pension law as well.
ESG Concerns For Trustees
As fiduciaries, trustees must act in ways that financially benefit the trust and its beneficiaries. Trustees who fail to do so are liable for damages to the beneficiaries, and may face additional legal penalties. The social and environmental goals involved in ESG investing create a greater potential for violations of fiduciary law by introducing motives for investment choices outside the traditional definition. Are trustees selecting ESG-focused mutual funds because they believe they are suitable investments, or do they merely hope to make the world a better place by deploying capital under their control according to socially pressured or personally held beliefs?
Trustees may sometimes have reasons for selecting an ESG investment strategy that is consistent with their fiduciary duties. Some investors argue an ESG strategy is not only morally right, but also a way to ensure better investment returns. Supporters of this position claim ESG investments are less risky and should lead to better long-term returns than non-ESG investments. Academics and analysts investigating this question have sometimes found data to support it, and in other cases have said the data is inconclusive.
As our colleague Paul Jacobs pointed out in his previous commentary “Greener Prospects For ESG Investing,” it seems likely that ESG investments will perform cyclically with the rest of the market in the long term. But certainly there will be periods when ESG investments will do better than non-ESG investments, and other times when they will do worse. This is especially true since it is difficult to define which companies or strategies are even considered ESG compliant, since there is not a clear or universally agreed-upon definition.
All of this ambiguity means that trustees and other fiduciaries must tread carefully when implementing an ESG-focused investment strategy.
This is because the “sole interest” rule, which is effectively imposed by ERISA and which also applies in many other fiduciary arrangements, requires a trustee to make decisions solely in the interest of a trust’s beneficiary. In other words, absent details in the trust documents specifying otherwise, a trustee cannot consider any factors other than the long-term benefits paid to, or accruing for the benefit of, a trust’s beneficiaries. A trustee prioritizing ESG factors for the sake of advancing environmental or social agendas may violate this rule, especially if those priorities stem from the personal beliefs of the trustee (or the managers the trustee may select). However, a trustee who integrated ESG funds into a trust’s investment portfolio because he or she believed such investments would generate better risk-adjusted returns would not be in violation of the sole interest rule. The intentions of the trustee matter; thus, documenting those intentions is important.
This, at least, is the distinction that Robert Sitkoff, a law professor at Harvard University, has proposed. Financial and legal experts have considered this hypothesis. The broad consensus is that fiduciary principles do not require trustees to consider ESG factors when selecting investments. However, trustees may consider ESG factors if, and only if, trustees expect better portfolio performance in the long run as a result. Again, the ability to substantiate the intentions and reasonsings of the trustee’s investment decision making is crucial.
By justifying ESG integration with measurable performance data and intentions in line with their fiduciary obligations, trustees can satisfy their “duty of loyalty,” which disallows fiduciaries from acting in pursuit of any objectives outside of the beneficiary’s. The duty of loyalty rule was originally designed to prevent trustees from making self-serving or professionally advantageous moves. However, the duty of loyalty also applies if the trustee makes investment decisions aimed at making the world a better place without demonstrating that those decisions are also in the beneficiary’s financial interest in the context of the trust’s purposes.
Practical Considerations For Trusts And Small Business Owners
The laws governing trusts are designed to provide grantors – the individuals or entities that establish trusts – control over the trust’s desired purpose and operation. The rules limit the trustee’s flexibility to make decisions, unless such flexibility is specifically included in the trust documents when drafted.
While the sole interest rule is the default, grantors can proactively waive or better define “sole interest” at their discretion. In such cases, the duty of loyalty means the trustee can consider factors other than investment performance in making investment decisions. However, trustees must still only select options that are in the best interest of the beneficiary and consistent with the rules of the trust. Such provisions are common for trusts that hold real estate or other non-income-producing assets. Such assets may not create the best long-term financial outcomes for trust’s beneficiaries, but the assets may hold personal or family value to the grantor, the beneficiaries or both.
If you plan to establish a trust and want your trustee to favor ESG investment strategies, either exclusively or as part of a broader investment approach, it is critical that you work with your estate planning attorney to create a trust framework that makes this desire clear. Because of the legal restrictions on fiduciaries that we have just discussed, you cannot rely on an informal understanding of your wishes, or your beneficiaries’ wishes.
An ESG strategy may also need to change as legislators and regulators establish new rules and legal frameworks. It is generally good practice to provide a degree of flexibility for your trustee to adapt and modify investment strategies over time. For example, if your trust documents dictate a strict ESG investment mandate, your trustee may not be able to deviate from it, even if it becomes obvious that an ESG strategy has substantially lower performance than you expected, provides little of the social benefit you hoped to support, or both. In this way, you may needlessly limit the benefits of the trust.
If you are a trustee yourself, you should take care to document the reasoning behind any ESG investment choices you make. In this documentation, explain how the choices are consistent with either the sole interest rule (if you believe the funds will offer better returns than alternatives) or the duty of loyalty (if the trust is structured to favor an ESG investment strategy). If you are ever unclear on your fiduciary obligations, it is best to consult an expert, who can help you to understand your duties and how best to document your actions to prove you are fulfilling them.
For a practical example, let’s consider a trust created by a grandfather to benefit his two adult grandchildren, Charles and Oliver. The trust document makes no specific mention of ESG investment strategies at all. Charles is highly concerned with climate change and wants the trustee to favor an ESG strategy that focuses on clean and renewable energy, and avoids companies with large carbon footprints. Oliver is less interested in ESG investments and prefers that the trustee solely focus on maintaining a highly diversified portfolio with the goal of maximizing risk-adjusted returns. Oliver is fine with some allocation to traditional energy, fossil fuel companies and other non-ESG-focused investments. (This example uses climate change as the primary ESG factor, but the scenario would work with diversity and inclusion, opposition to unfair labor practices, religious freedom issues, or any set of ESG concerns that one beneficiary may focus on that the other does not particularly care about.)
In this example, if the trustee implements a portfolio focused on climate change issues, and if the trust has a measurable performance deficit as compared to a more balanced and diversified portfolio, it is possible for Oliver to bring a legal challenge against the trustee for failing to manage the trust under fiduciary law. Oliver can claim the trustee was more focused on using trust assets to mitigate climate change than on maximizing the trust beneficiaries’ financial benefits. The trustee would be especially vulnerable to this claim if he or she had not documented his or her intentions and the due diligence process of selecting particular ESG investments, demonstrating how they were consistent with a prudent investment strategy. And even if Charlies and Oliver agreed on an ESG investment strategy, the trustee would still need to consider the interests of any remainder beneficiaries of the trust.
Some trusts have provisions that allow a trustee to divide a trust for multiple beneficiaries into separate trusts for each beneficiary. This approach would allow the trustee to tailor investment strategies to the needs and desires of each beneficiary. Again, trustees must stay mindful of remainder beneficiary interests that may vest in the future, usually at the death of the primary beneficiary. Grantors creating trusts may wish to also address ESG investment strategies when drafting trust documents. Trust documents could either allow or limit a trustee’s ability to focus on ESG investments. In any of these situations, trustees must take care to document their intentions and periodically review their investment strategy to ensure it remains consistent with the trust’s purposes and stays in line with fiduciary principles.
Charitable trusts have their own version of the sole interest rule. These trusts benefit a recognized charitable organization, rather than individual beneficiaries. By law, trustees for charitable trusts must work “solely in furtherance of [the trust’s] charitable purpose” unless the terms of the trust allow otherwise. Investing in companies that support the trust’s objective, and avoiding companies whose actions run counter to the charitable beneficiary’s mission, is one way to fulfill this duty. For instance, the charitable trust of a zoological foundation might invest in ESG funds with a focus on wildlife conservation, and avoid holdings associated with timber and logging operations. In circumstances in which the chosen investments demonstrably line up with the trust’s purpose, the environmental, social or governance benefits are no longer incidental; they are one and the same with the organization’s charitable goal. Trustees should be prepared to demonstrate, however, the ways in which the benefits directly align with the charity’s purpose.
Small Business Considerations
Small business owners providing qualified retirement plans subject to ERISA also need to be cautious about integrating ESG principles. Offering investments with goals other than maximizing financial benefits within retirement plans is not prohibited outright, but it can still lead to regulatory trouble.
Although ERISA regulation on retirement plans does not name the sole interest rule explicitly, small business owners should be aware that legislation states the “exclusive purpose” of fund menus they offer must be to provide “financial benefits” for plan beneficiaries. Small business owners crafting a list of investment options for employees enrolled in work-sponsored retirement plans cannot give precedence to any externality, such as ESG goals, when choosing funds. While you may be able to include some ESG funds on a menu among which participants can freely choose, you might need to offer certain disclosures. Employers likely could not offer a plan in which the only investment options were ESG funds. If you want to make ESG funds available in retirement plans governed by ERISA, it would be wise to consult a lawyer or other legal expert to ensure you aren’t violating the law unintentionally.
Some small businesses have incorporated ESG ideas in other ways, as regulatory and popular perceptions continue to shift. Many boards and executives have implemented ESG values, and language about them, into company policy due to concerns about reputation and future profitability. Some have established audits or created committees to address these issues. There is nothing wrong with this approach on its face. However, business owners should understand the arenas in which they will need to balance such concerns with fiduciary duties to employees and other stakeholders before instituting such policies.
Authorities are likely to continue to tighten fiduciary regulations related to ESG investing. In 2021, the Employee Benefits Security Administration proposed an amendment to the language of the current duty of loyalty standard, designed to better reflect the modern investment landscape. Small business owners, trustees and other fiduciaries should stay up to date with current policies to legally protect themselves and the assets they manage.
As ESG investing evolves, more people may want their trusts or employer-provided retirement plans to reflect their values. Those creating trusts should consider the goals they wish to achieve, financial or otherwise, and in appropriate situations discuss them with their beneficiaries. At the same time, trustees and managers subject to fiduciary duty should take special care to document their decisions if they incorporate ESG considerations into their investment strategy. No one wants good investment intentions to lead to bad outcomes.