Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee.

• Author: Schanzenbach, Max M.

Table of Contents Introduction I. Socially Responsible Investing, Collateral Benefits ESG, and Risk-Return ESG A. The Rise of SRI B. SRI and Fiduciary Principles C. From SRI to ESG D. Differentiating Collateral Benefits ESG from Risk-Return ESG II. Fiduciary Loyalty and ESG Investing A. "Sole" Versus "Best" Interest B. ESG and Loyalty in ERISA Law 1. Solely for "financial" benefits 2. Applied to ESG investing by a pension trustee 3. Collateral benefits as a tiebreaker? C. ESG and Loyalty in Trust Law 1. The "sole" interest rule by default 2. Applied to ESG investing in a private trust 3. Collateral benefits and the terms of a trust 4. Collateral benefits and authorization by the beneficiary D. ESG and Loyalty in Charity Law 1. The "sole" interest rule and "charitable purpose" 2. "Best" rather than "sole" interest applies to many charities III. The Duty of Prudence and ESG Investing A. The Prudent Investor Rule B. Identifying and Applying ESG Factors C. ESG Factors and Firm Performance D. ESG Factors in Active Investing 1. Questioning market efficiency 2. Screens and stock picking 3. The usual caveats about stock picking 4. Contrarian and anti-ESG strategies E. ESG Factors in Active Shareholding F. ESG Investing Is Permissible but Not Mandatory Conclusion Introduction

Trustees of pensions, charities, and personal trusts invest tens of trillions of dollars of other people's money subject to a sacred trust known in the law as fiduciary duty. (1) Trustees must act in the sole interest of the beneficiaries (the duty of loyalty (2)) and construct a diversified portfolio with risk and return objectives reasonably suited to the purpose of the trust (the duty of prudence (3)). A trustee who breaches these duties is subject to make-whole damages and other remedies, thus containing the agency costs that arise from the separation of ownership and control inherent to the trust form. (4)

Over the past decade, trustees have come under increasing pressure to consider environmental, social, and governance (ESG) factors in their investment decisions, for example, by divesting from fossil fuel, tobacco, or firearms companies, or otherwise accounting for environmental or social costs in making investment decisions. (5) A group convened by the United Nations, the Principles for Responsible Investment (PRI), along with a growing and influential group of scholars and practitioners, has even taken the position that fiduciary principles require a trustee to use ESG factors. (6) Yet many American trustees continue to resist explicit use of ESG factors on the grounds that to do so would entail consideration of collateral benefits to third parties in breach of the sole interest rule imposed by the trust law fiduciary duty of loyalty. (7)

This Article reconciles these contrasting views by undertaking a balanced assessment of the law and economics of ESG investing by a trustee of a pension, charity, or personal trust. (8) We show that, in general, ESG investing is permissible for a trustee of a pension, charity, or trust subject to American trust fiduciary law if: (1) the trustee reasonably concludes that the ESG investment program will benefit the beneficiary directly by improving risk-adjusted return; and (2) the trustee's exclusive motive for adopting the ESG investment program is to obtain this direct benefit.

Given the current state of the theory and evidence on ESG investing, we conclude that an ESG strategy can satisfy these conditions under the right circumstances. However, a particular ESG strategy will not necessarily satisfy a trustee's fiduciary duties and, even if such a strategy is permissible in a particular circumstance, the strategy must be regularly reassessed and updated as circumstances change. Moreover, contrary to the PRI and others, we show that a trustee is not required to consider ESG factors. Our analysis therefore challenges both the current Zeitgeist in favor of ESG investing by a trustee and common knee-jerk reactions that ESG investing necessarily violates the duty of loyalty.

Clarifying the law and economics of ESG investing by a trustee is of critical importance. With the investment of tens of trillions of dollars at stake, the conflicting commentaries and advisories--including by regulators--require resolution. For example, the U.S. Department of Labor has issued a series of bulletins, including three in the last few years (2015, 2016, and 2018), that address the legality of ESG investing by a pension trustee subject to federal law, each purporting to clarify the prior one. (9) Despite these bulletins, in 2018 the Government Accountability Office (GAO) urged the Department of Labor to issue still further guidance. (10) In 2019, the President ordered the Department of Labor to review its existing guidance "to ensure consistency with current law and policies that promote long-term growth and maximize return on [pension] plan assets." (11) Meanwhile, in 2018, Delaware amended its trust code to specifically address ESG investing by a trustee, becoming the first state to do so. (12) But because this amendment deviates from traditional trust fiduciary law, its instructiveness outside of Delaware is uncertain at best. (13) Casting a glance abroad, we find that regulators in the United Kingdom and European Union have also taken up the question of ESG investing by trustees, but with conclusions that conflict with those of American regulators. (14)

Confusion about the propriety of ESG investing by a trustee has been amplified by the growing salience of ESG investing generally. As of November 2019, over 1,900 asset managers have signed the PRI's statement of principles on ESG investing, including many of the world's leading institutional investors. (15) Hundreds of commercial ESG indices provide ESG ratings of individual companies, (16) and an S&P 500 ESG index is in preparation. (17) Even index funds, such as those managed by Vanguard and BlackRock, which traditionally avoid consideration of firm-specific factors, are increasingly focusing "on issues ranging from executive pay to climate change." (18) In the words of Goldman Sachs, "ESG investing, once a sideline practice, has gone decisively mainstream." (19)

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. (20) ESG investing finds its roots in the socially responsible investing (SRI) movement that came to the fore in the 1980s as part of a divestment campaign aimed at South Africa's apartheid regime. (21) Other labels for the practice include ethical investing, economically targeted investing, sustainable or responsible investing, and impact investing. (22) In accordance with prevailing contemporary usage, we will use the term "ESG investing." (23) The original motives for ESG investing were moral or ethical, based on third-party effects rather than investment returns. Such motives run afoul of the duty of loyalty under trust fiduciary law, which imposes a "sole interest rule" that requires a trustee to consider only the interests of the beneficiary without regard for the interests of anyone else, whether the fiduciary personally or a third party. (24) In the late 1990s and early 2000s, however, proponents of SRI rebranded the concept as ESG by adding corporate governance factors (the G in ESG), and they asserted that ESG investing could improve risk-adjusted returns, thereby providing a direct benefit to investors. (25) 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. (26) On this view, ESG investing is a kind of profit-seeking, active investment strategy that can be consistent with the fiduciary duties of loyalty and prudence. (27)

On the assumption that ESG investing can provide risk and return benefits, an influential 2005 report sponsored by the UN working group that preceded the PRI and prepared by the international law firm Freshfields Bruckhaus Deringer argues that ESG investing is consistent with fiduciary duty and, even more, that considering ESG factors "is arguably required in all jurisdictions." (28) In a 2015 follow-up report, the PRI took the position that it had "end[ed] the debate about" ESG and fiduciary duty, concluding that "there are positive duties on investors to integrate ESG issues." (29) Other commentators have argued likewise. (30) Nonetheless, many American trustees remain skeptical about the permissibility of ESG investing, probably owing to its association with the morality- and ethics-based practices of what had been called SRI. (31)

Our analysis makes four main contributions. First, we clarify the umbrella term "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. This taxonomic clarity, which differentiates between kinds of ESG investing based on motive, cuts through the existing noise and clutter by tracking the duty of loyalty in trust fiduciary law, which likewise emphasizes motive. (32) We show that collateral benefits ESG violates the sole interest rule of trust fiduciary law, (33) subject to certain special rules for charities and for settlor or beneficiary authorization in personal trusts. (34) Risk-return ESG investing, by contrast, can be permissible on the same terms as any other kind of active investment strategy that seeks to exploit market mispricing (what we will call active...