Mind the Gap: Fiduciary Risk in ESG Investing
Editor’s note: Evercore Wealth Management provides customized environmental, social and governance, or ESG, investment services to families, family trusts, foundations and endowments.
Additionally, Evercore Trust Company can serve as a sole trustee or as co-trustee, or can provide comprehensive fiduciary support as an agent to individual trustees. Here, Chris Zander, CEO of Evercore Wealth Management and Evercore Trust Company, interviews two leading authorities on trust law about the risks faced by trustees of ESG portfolios. We will address managing the issues raised here and related topics in future issues of Independent Thinking.
Max Schanzenbach is the Seigle Family Professor of Law at Northwestern University School of Law. His research uses economic theory and statistical methods to assess the real-world effects of law and legal institutions in a variety of fields, including trust and fiduciary law. A widely published scholar, he is also a former editor of the American Law and Economics Review.
Robert Sitkoff is the John L. Gray Professor of Law at Harvard Law School. His research and teaching focuses on economic and empirical analysis of trusts, estates, and fiduciary administration. He is the surviving author of Wills, Trusts, and Estates, the most popular American coursebook on trusts and estates, and a coeditor of The Oxford Handbook of Fiduciary Law.
Together, they recently published Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee in the Stanford Law Review.
Q: High net worth investors, foundations and endowments are increasingly interested in and indeed often passionate about ESG investing. We work with clients to meet their ESG goals, without sacrificing returns or taking on too much investment or fiduciary risk. What do you see as the risks for fiduciaries?
ESG investing resists precise definition, but roughly speaking, it is an umbrella term that refers to an investment strategy that emphasizes a firm’s governance structure or the environmental or social impacts of the firm’s products or practices.
The original motives for ESG investing were moral or ethical, based on third-party effects rather than investment returns. In the late 1990s and early 2000s, proponents of socially responsible investment, or SRI, rebranded the concept as ESG by adding corporate governance factors (the G in ESG). Moreover, some asserted that ESG investing could improve risk-adjusted returns, thereby providing a direct benefit to investors.
For example, instead of avoiding the fossil fuel industry to achieve collateral benefits from reduced pollution, ESG proponents argued that the fossil fuel industry should be avoided because financial markets underestimate its litigation and regulatory risks, and therefore divestment would improve risk-adjusted return. On this view, ESG investing can be a kind of profit-seeking, active investing strategy. ESG investing may also be implemented via shareholder voting or other engagement with management (we call this active shareholding or stewardship, in contrast to active investing by picking and choosing securities).
We clarify ESG investing by differentiating it into two categories. We refer to ESG investing for moral or ethical reasons or to benefit a third party – what had been called SRI – as collateral benefits ESG. We refer to ESG investing for risk and return benefits – that is, to improve risk-adjusted returns – as risk-return ESG.
For a trustee or other fiduciary investor, the motive or purpose for using ESG factors is of critical legal significance. You asked about the risks for fiduciaries. The answer turns on the fiduciary’s motive; that is, whether the fiduciary is undertaking collateral benefits ESG or risk-return ESG.
Q: All trustees, individual and corporate, must act with a duty of loyalty and a duty of care or prudence. Do ESG investing strategies that seek to advance specific causes – what you are calling collateral benefits ESG – fall outside those responsibilities?
The trust fiduciary law duty of loyalty, which is applicable not only to trustees of private trusts but also to ERISA fiduciaries, imposes a “sole interest” or “exclusive benefit” rule.1 The trustee or other fiduciary must act in the sole interest and for the exclusive benefit of the beneficiary. Accordingly, ESG investing to benefit a third party or advance a specific cause – what had been called SRI and what we call collateral benefits ESG – ordinarily violates the trust fiduciary duty of loyalty.
ERISA makes the sole interest rule mandatory as a matter of federal law. Neither a plan sponsor nor a plan participant can authorize deviation from the sole interest rule under ERISA. Under current Supreme Court precedent, moreover, the relevant sole interest is limited to the financial interests of the participants.
Under state trust law, by contrast, the sole interest rule is a default that in theory can be overcome by authorization in the terms of the trust or by the beneficiaries. In practice, however, authorization is complicated, and much will turn on the circumstances. There is variation across the states on how much leeway a grantor can give a trustee in the terms of a trust, and authorization by a beneficiary is fraught because it must be fully informed – and there are also questions of temporal scope.
A charitable endowment will typically have a little more flexibility. If a specific cause falls within the organization’s charitable purpose, then pursuit of that cause via endowment investment is a substitute for expenditure (what is sometimes called mission- or program related investment), and so not a loyalty breach. Furthermore, charities are often organized as corporate or other entities rather than as a trust, in which case the application of duty of loyalty may be less strict.
Q: Are some ESG strategies riskier than others from a legal point of view? For example, how does using ESG factors as a component of the underlying decision-making compare with more focused, less diversified strategies (public or private) that advance particular interests?
Collateral benefits ESG ordinarily violates the sole interest rule of the trust law fiduciary duty of loyalty. Risk-return ESG, by contrast, is consistent with the sole interest rule, because by definition the purpose is pursuit of improved risk-adjusted returns.
Instead, the question for a given risk-return ESG strategy is whether it satisfies the duty of care or prudence, and in particular, the prudent investor rule. That rule neither favors nor disfavors any particular type or kind of investment strategy. Instead, as set forth in the Uniform Prudent Investor Act, the prudent investor rule requires “an overall investment strategy having risk and return objectives reasonably suited to the trust” and, other than in exceptional circumstances, requires a fiduciary to “diversify the investments of the trust.” The rule is explicit in not adopting a specific investment strategy or prohibiting specific types of investments.
So a risk-return ESG strategy will be judged under the prudent investor rule on the same terms as any other investment strategy. In light of the current theory and evidence on ESG investing, we believe a program of risk-return ESG could well satisfy the prudent investor rule. As with any strategy, the individual fiduciary must support his or her choices, and the corporate fiduciary its choices, with a reasonable analysis concluding that the risk-return benefits of the strategy offset any associated costs, and that the risk and return objectives of the strategy are suited to the trust. In accordance with the duty to keep adequate records, the fiduciary’s analysis of these considerations must be documented in the fiduciary’s files.
Q: If the performance of an ESG strategy is lagging that of a more traditional strategy – or taking on more risks – does that force a rethink from a fiduciary point of view?
The fiduciary duty of prudence also requires ongoing monitoring. After implementing a prudent investment program, whether based on ESG factors or otherwise, a fiduciary must continue to monitor costs and returns, and adjust the program in light of actual performance and changing circumstances. In the words of the Supreme Court, “a trustee has a continuing duty to monitor trust investments and remove imprudent ones,” and “[t]his continuing duty exists separate and apart from the trustee’s duty to exercise prudence in selecting investments at the outset.”
Q: Some proponents of ESG investing, including the U.N.-backed Principles of Responsible Investing, or PRI, have argued that a fiduciary not only can but must use ESG factors. What is your view?
The claim that ESG investing is or should be mandatory under American trust fiduciary law is wrong. Under the prudent investor rule, there are no categorical rules of permissible or impermissible investments. Instead, as under the Uniform Prudent Investor Act, “[a] trustee may invest in any kind of property or type of investment,” as long as the investment is “part of an overall investment strategy having risk and return objectives reasonably suited to the trust.”
A simple way to see the folly of the PRI’s position is that it would make a passive market index without an ESG wrapper illegal for a trustee or other fiduciary investor. That is not the law. To the contrary, in the words of the Supreme Court, a trustee “could reasonably see ‘little hope of outperforming the market,’” and therefore “prudently rely on the market price.” To put the point more directly, a total market index is not a per se illegal investment for a trustee or other fiduciary.
There is also the difficulty that the ESG rubric is too fluid, and the application of ESG factors too subjective, to lend itself to a mandate. There are hundreds of ESG ratings services, for example, and they often disagree. The subjectivity inherent to ESG investing, and the fluidity of the ESG rubric, casts a pall over the practical feasibility of a mandate.
Q: Nevertheless, industry proponents of ESG, who grow in numbers every day and now include some very well-known investors, Larry Fink of BlackRock among them, are encouraged by evidence that ESG strategies can improve risk-adjusted returns. Do you believe that the evidence is now sufficient to merit a change in trust law?
In light of the current theory and evidence on ESG investing, a program of risk-return ESG could well satisfy the prudent investor rule. But so could a contrarian investing strategy or a passive market index fund. Whether a given investment strategy is prudent will depend on the particular circumstances. There is no need for a change in trust fiduciary law to accommodate prudent ESG investing. And there is no guarantee that risk-return ESG investing, even if an effective strategy now, will continue to be effective in the long run. In particular, active trading based on ESG factors relies on those factors being mispriced in the market today. If ESG grows more popular among investors, those factors should no longer be mispriced, making the strategy less effective.
For more information on the investment and fiduciary issues related to ESG strategies at Evercore Wealth Management and Evercore Trust Company, please contact Chris Zander at firstname.lastname@example.org.
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