Although obviously all forms of investing are affected by the stock market’s recent decline, an important longer-term trend involves socially-responsible investing (SRI). SRI has generally increased in popularity in recent years, and by some calculations, now accounts for more than $2 trillion in U.S. investments.
An SRI strategy generally considers both an investor’s financial needs and an investment’s effect on society as a whole, and constitutes the commitment of money to gain a financial return in a manner that applies good judgment and sound thinking to matters that positively affect human welfare. Typically, investors who engage in SRI make investments in companies that seek to improve the environment, have reputable human rights and labor practices, and/or implement good corporate governance practices.
Before offering SRI options as part of an investment strategy, however, trustees must carefully consider their fiduciary obligation to investors and the potential liability for a breach of this obligation due to the SRI option. While we are not aware of any significant litigation on these issues to date, it is better to be safe than sorry.
Fiduciaries and fiduciary duty
Generally, a fiduciary is a person (or entity) who owes a legal duty derived from an undertaking to act primarily for the benefit of another person or entity in connection with that undertaking. Employers that sponsor certain benefit plans, such as 401(k) and pension plans, are fiduciaries. Third-party administrators that administer such benefit plans also may serve as fiduciaries, although a third-party administrator will often attempt to define itself as an agent of the fiduciaries and not a fiduciary in its own right. Trustees owe a fiduciary duty to trust beneficiaries and act as a fiduciary when managing trust assets. Various other individuals and entities, such as certified financial planners and investment advisors, also act as fiduciaries.
Fiduciary duty differs based on the role the individual (or entity) undertakes. Generally, a fiduciary owes a duty of loyalty and a duty of care to its clients and/or beneficiaries.
? The duty of loyalty requires the fiduciary to act in the best interest of the client or beneficiary. This duty must take precedence over the personal interests of the fiduciary and requires, for example, that the fiduciary must avoid conflicts of interest or, at a minimum, apprise the client or beneficiary of potential conflicts and obtain knowing consent.
? The duty of care requires the fiduciary to consider all material information when making a decision on behalf of a client or beneficiary.
? Although a duty of good faith is sometimes analyzed separately when determining whether a fiduciary breached his or her duty of loyalty or duty of care, the duty of good faith often is assumed to be part of the duties of care and loyalty.
Overall, a fiduciary must perform his or her duties with the appropriate care, skill, prudence and diligence that would be exercised by a prudent person in like circumstances. Under this general prudent person standard, a fiduciary is expected to apply generally accepted investment theories competently in the context of the rules governing the portfolio under their purview.
SRI and trust investment standards
In administering a charitable trust, for example, the trustee may have, or appear to have, more flexibility in engaging in SRI than where there are individual beneficiaries involved. The Uniform Prudent Management of Institutional Funds Act (UPMIFA), which has been adopted in many states and generally applies to institutional investments of a charitable nature, allows consideration of, among other things, an asset’s relationship or special value to the institution’s charitable purposes. In some states, however, such as Virginia, consideration of the institutional investment’s charitable nature is required, assuming such consideration is relevant to the management of the institution’s investments. For example, it would be appropriate for certain nonprofit organizations that seek to preserve natural resources and end global warming, to engage in SRI by investing in companies that help reduce carbon emissions or that safely remove contaminants from water, soil, air, etc..
Whether the trust is charitable or individual, however, it is critical that a trustee adhere to and abide by the often statutorily imposed and common law fiduciary duty of loyalty. A trustee has always been bound by a duty of loyalty to the beneficiaries of the trust. This duty originates from the creation of the trust itself. Many states have adopted the Uniform Trust Code (UTC) to codify their common law regarding the administration of trusts. Commonly, a state’s version of the UTC adopts the Uniform Prudent Investors Act (UPIA), which (unless made subject to modification by the trust document) interprets the duty of loyalty to place some potentially significant restrictions on SRI.
Article 5 of the UPIA emphasizes that the trustee’s duty of loyalty is “solely in the interest of the beneficiaries.” Commentary to Article 5 addresses the sometimes-tense intersection between a trustee’s fiduciary duty of loyalty and the grantor’s direction to invest in a socially-responsible manner. The commentary states that SRI is inconsistent with this duty to beneficiaries if the “investment activity entails sacrificing the interests of the trust beneficiaries.” This commentary provides an example of such a sacrifice in the form of a trustee accepting below-market returns from investments supporting a particular social cause. Thus, a trust may dictate that the trustee invest in particular socially-responsible ways, but if the trust is held to the standards under the UPIA, the trustee also has a duty to the beneficiaries to invest and act first in the interests of the beneficiaries.
There are generally, however, ways of harmonizing the UPIA’s emphasis on loyalty to beneficiaries with a grantor’s desire to further SRI. First, many states permit the UPIA standards to be modified or eliminated altogether by the terms of the trust. This makes it important both to know what the local law does allow and to draft trust documents with care. Grantors are well-advised to be clear about how they want the trust to be invested by including statements of intent (within the trust agreement) explaining what they want.
For example, a grantor may want to include in the terms of the trust agreement an express intent to further socially-responsible investing even where there is a possibility that such investing may not lead to the greatest possible return available in the market. This statement of intent may be then given as a direction to the trustee, with examples of what types of SRI would be acceptable. These examples would not necessarily limit the trustee, nor grant complete discretion. Trusts are still subject to the mandatory rules of the UTC that require trustees to act in good faith in serving both the purposes of the trust, so long as they are legal, and the beneficiaries’ best interest. No amount of drafting can successfully negate a trustee’s fiduciary duty, and quite rightly so. However, directing the trustee to engage in SRI as one of those purposes instructs the trustee to act in the best interests of the beneficiaries, but to do so when and by following the grantor’s SRI intent.
Second, even in states that do not permit grantors as much leeway to negate the UPIA requirements, the UPIA would only prevent trustees from making real choices between social responsibility and return, not false ones. A trustee who reasonably concludes that a socially-responsible investment is likely to provide a risk-return profile that is as good as, or better than, a less socially-responsibility investment should not expect to face UPIA liability for picking the socially-responsible one.
Grantors and trustees should also be cognizant of the potential arguments that adhering to SRI requirements might increase administrative costs and/or minimize diversification. A beneficiary might conceivably argue that the need for due diligence and increased research to meet SRI criteria increases the costs of administering the trust, or that the limit to SRI criteria results in a smaller, less diverse–and therefore, more risky–pool of investments from which the trustee has chosen. The trustee can argue that neither of these points is true in practice.
On administrative costs, implementing any investments requires due diligence, and the expense of the process may not differ materially (or at all) between SRI and other investments. (Indeed, the situation may cut the other way: it may take less time to examine a company that is LEED certified for its environmental policies, than to assess the risk of investing in one known for having pollution problems).
On diversification, no trust can buy every possible investment. Presumably, the list of socially-responsible investments would be broad enough to construct as diverse a portfolio of financial risks and reward as one that did not take social-responsibility into account. But the clearer the trust instrument is in providing for SRI, the easier it is for the trustee to respond to these types of arguments.
SRI and fiduciary liability issues
There may also be a disagreement between the client or trust beneficiary and the fiduciary as to what constitutes SRI. Take, for instance, investments in environmentally friendly companies such as those that build or manage wind farms. These companies create energy by producing little or no pollution. Presumably, such companies would be seen as an appropriate investment for someone seeking to engage in SRI.
But what about an automobile company that produces hybrid cars? On the one hand, hybrid cars reduce carbon emissions, at least when compared with traditional cars that operate solely on gasoline or diesel fuel, and in that regard they are considered environmentally friendly. On the other hand, the same manufacturers produce cars that emit amounts of carbon into the atmosphere–and the hybrid cars emit carbon as well. Are these manufacturing companies appropriate investments when practicing SRI?
What about utilities? Such companies typically are large emitters of carbon, but some are far more efficient than others. For example, some companies are using carbon capture technology or are implementing practices that allow their facilities to operate more efficiently without emitting as many pollutants. Should the companies that have made significant investments in technology that have reduced or will substantially reduce carbon emissions (and other pollutants) be considered appropriate for SRI?
What about evaluating human rights or labor practices? During the days of apartheid in South Africa, some people believed that social responsibility required withholding investments from all South African companies out of concern that such investments would contribute to apartheid. Others believed that social responsibility required supporting those South African companies that appeared to be working against apartheid. Likewise, how should a company’s overall human rights or labor practices be evaluated? A company may have “employee friendly” policies and practices (such as on-site child care and anti-discrimination and leave policies that provide protection beyond what is required in each jurisdiction applicable to the employer), but the company may have been sued numerous times for alleged employment law violations. Should the number of lawsuits matter? Should it be the number of verdicts? Or should there be some other criteria? Also, one company may have excellent practices here in the United States, but that same company may export many jobs to other countries where it pays significantly lower wages to workers–perhaps below or even barely above the poverty line. As these (and many other possible) examples illustrate, what constitutes “social responsibility” is by its nature a values-driven process and not everyone necessarily shares the same values.
Differing views about what constitutes SRI may leave a fiduciary exposed to liability. For example, a client or beneficiary may claim breach of fiduciary duty based on the client’s or beneficiary’s belief that the fiduciary did not make a socially-responsible investment. The theory behind such claims would vary from state to state, but, generally, they would allege that a fiduciary misrepresented the types of investments the fiduciary intended to make, or failed in a fiduciary responsibility to carry out the beneficiary’s instructions.
Claims might also be brought under common law fraud or negligent misrepresentation theories. Similarly, claims might be brought pursuant to consumer protection or deceptive trade practices acts. These latter claims mostly fall under state statute, and thus will vary from state to state. Like the common law claims, such statutory claims could allege that the fiduciary intentionally misled investors or the fiduciary’s description of his/her investment objectives was deceptive or subject to confusion.
These legal theories are generally untested, and we would expect that a fiduciary would have some significant defenses to them. To illustrate, is it possible for a client or beneficiary who specifically instructs a fiduciary to engage in SRI to bring one or more of these claims if the fiduciary placed that client or beneficiary in a fund that invests in a utility when the utility has invested substantial funds in reducing carbon emissions and is an industry leader in this regard? Presumably, fraud and claims of a similar nature cannot be brought under such a scenario–at least not successfully–provided that the fiduciary defines the SRI mission broadly enough so that the investment decisions are consistent with the client’s or beneficiary’s investment objectives, including, but not limited to, SRI.
Likewise, fiduciaries may defend such claims by arguing that they exercised the appropriate care, skill, prudence and diligence in making the investments and the investments were consistent with the client’s or beneficiary’s objectives, including, but not limited to, SRI. A fiduciary may gain protection from such claims by clearly stating, in advance, that investment decisions as to what constitutes socially responsible shall remain solely within the fiduciary’s discretion. This statement may be included in trust documents or the investment policy statement. The fiduciary may also be well-advised to record and to inform clients, at the time of investment, of the reasons why the fiduciary considered investments to be socially responsible.
This is good advice not merely because it avoids lawsuits, but because it is good to keep clients informed. However, it important in presenting these reasons that the fiduciary act prudently to determine that the facts behind them are accurate. Telling a client that the fiduciary invested in a company because it was “green,” may give rise to lawsuit if this turns out to be untrue.
Even if a fiduciary does not take such precautionary measures, there are still some significant impediments to a common law or statutory claim premised on a fiduciary’s decision to invest in companies that do not meet the client’s or beneficiary’s definition of SRI. To begin with, the room for honest disagreement over what is socially responsible makes it difficult to be certain about when that duty is breached. Although all investment involves judgment and room for disagreement, there are clearer standards for establishing when investments are unsuitable financially than when they might be unsuitable socially.
Moreover, the law requires the claimant not only to prove a fiduciary duty was breached, but that the claimant suffered damages as a result. A client or beneficiary who contends that the fiduciary breached his duty by failing to comply with the client’s or beneficiary’s investment instructions or criteria would have to be able to point to a specific loss in his or her portfolio that can be directly attributed to the fiduciary’s failure to follow his or her instructions.
When investments are alleged to be financially unsuitable, the damages may be apparent. For example, suppose a 65-year-old client informed his investment advisor that he is seeking to achieve a steady income from his investments, but the investment advisor loses most of the client’s money by investing it primarily in small high-tech companies with high growth potential that don’t pay dividends. In such a situation, there is a strong argument that the fiduciary breached a fiduciary duty by disregarding the client’s investment objectives and that decision resulted in a loss to the client’s portfolio.
When investments are alleged to be socially unsuitable, the damages may not be so clear. If, for example, the 65-year-old claimed that his fiduciary did not create a portfolio that fit the definition of SRI, it may not be clear in what ways the portfolio was socially unsuitable, and even harder to determine what loss flowed from that unsuitability. Similar obstacles are likely to arise under other causes of action, such as fraud and negligent misrepresentation. Perhaps the client could argue that the fiduciary should refund remuneration for having failed to comply with his or her duty. But even this requires that the duty be sufficiently clear to establish a breach justifying the remedy.
Special circumstances–SRI and ERISA
A fiduciary of a retirement plan is governed by the fiduciary standard set forth in the federal Employee Retirement Income Security Act (ERISA). The ERISA fiduciary standard is very specific and is found in ERISA Section 404(a). It provides that a fiduciary shall discharge his or her duties with respect to a retirement benefit plan solely in the interest of participants and beneficiaries and (a) for the exclusive purpose of providing benefits and defraying reasonable administrative costs; (b) with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in like capacity and familiar with such matters would use in the conduct of an enterprise of like character and with like aims (i.e., a prudent expert standard); (c) by diversifying the investments so as to minimize the risk of large losses, unless under the circumstances, it is clearly prudent not to do so; and (d) in accordance with the documents and instruments governing the retirement benefit plan insofar as such documents are consistent with the provisions of ERISA.
ERISA lawyers view this standard as different from the general “prudent person” standard described previously because it holds the ERISA fiduciary to a standard that assumes investment expertise that a generally prudent person might not have.
The most popular form of retirement plan is the defined contribution, or individual account balance, plan, such as a 401(k). A typical defined-contribution plan allows an employee to contribute his or her compensation pre-tax to a retirement plan. The employer often makes a matching contribution on behalf of the participating employee.
With respect to account balance plans, fiduciaries often make decisions about what investment choices will be offered to plan participants. Under ERISA section 404(c), if done correctly, the fiduciaries are not responsible for the individual’s actual investment choices but are responsible for the choice of which investment options to offer to plan participants.
In the ERISA investment context, this means that the fiduciary must offer a variety of investment options that achieve the retirement plan’s stated financial goals and avoid unreasonable costs.
Thus, when evaluating the suitability of an investment, a fiduciary must consider the retirement plan’s objectives and the risks of the investment, and conduct sufficient research to achieve a reasonable return in meeting those goals. The amount and type of research conducted will be measured against what a prudent fiduciary with investment expertise would do under similar circumstances.
Because obtaining a reasonable return for the retirement plan is of paramount importance for a fiduciary, it is fair to question whether and how SRI may factor into a fiduciary’s analysis of investment options in an ERISA context. The United States Department of Labor (DOL) stated in an opinion letter dated May 28, 1998 (No. 98-04A) that, when making an investment decision, a fiduciary generally must consider only how the investment will affect the retirement income of the plan participants and beneficiaries.
The DOL, however, also stated that a fiduciary is not precluded from considering “collateral benefits,” such as those offered by an SRI fund. According to the DOL, the collateral benefits offered by an SRI fund may be decisive in making an investment decision “only if the fiduciary determines that the investment offering the collateral benefits is expected to provide an investment return commensurate to alternative investments having similar risks.” In other words, economic returns take precedence in the decision making process under ERISA. However, the DOL also commented that when considering the appropriateness of an investment, a fiduciary must consider, among other things, the diversity of a portfolio, its liquidity and the risk/return characteristics.
Thus, according to the DOL, an ERISA fiduciary may not solely consider SRI when making an investment decision. The common understanding of the DOL opinion is that it generally discourages SRI considerations but concedes that, all other things being equal, using an SRI filter as a tie-breaker would not be a fiduciary violation.
Although at one point many people believed SRI yielded lower investment returns when compared to other alternatives, times have changed. In this regard, for example, as concerns about global warming and other developments affecting the environment (such as government regulation) increase, “green companies” will become increasingly important to our economy and, as a result, it may be considered prudent to include such investments in one’s portfolio particularly for the long-term investor. In fact, investing in such green companies, based on SRI strategies may increase a client’s or beneficiary’s long-term returns. Similarly, by avoiding companies that have poor environmental practices and are likely to face public or private litigation as a result, a fiduciary could arguably be avoiding risk. In either circumstance, overtly considering such return and risk factors in investment decisions would be indicative of a fiduciary fulfilling his or her duties.
If the ERISA plan is a defined benefit pension plan, the investment decisions are left entirely to the plan trustee. In the pension plan context, the duty of the plan trustee is to maximize investment return and minimize risk and to manage the pension plan assets for the exclusive benefit of plan participants. Again, if the plan trustee can demonstrate that the SRI investment option has a positive impact on investment returns, then the use of SRI investment options is not precluded.
The principles of fiduciary duty do not preclude SRI. However, fiduciary obligations may raise issues for socially reasonable investments. It is important that fiduciaries (and trustors) think carefully about how they will define SRI, so as to help reduce the risk of any claims being brought for not meeting a client’s or beneficiary’s expectation as to what constitutes an SRI option.
However, in some contexts, it will also be important for fiduciaries to remember that engaging in SRI arguably may be viewed as a fulfillment of one’s fiduciary duty, particularly as environmental concerns increase and investment in “green technology” becomes more important to our (and the global) economy.
Determinations of conformity to fiduciary duties generally hinge on evidence of the consistent application of sound processes. Careful documentation is especially important for fiduciaries engaged in SRI. Expressions of socially-responsible intent and authority, due diligence processes applied, and the basis for decisions reached should be recorded.
Good deeds should go unpunished, and perhaps even be rewarded, through conscientious adherence to fiduciary principles.
Merril Hirsh (Merril.Hirsh@troutmansanders.com), is a partner in the Washington, D.C., office of the law firm Troutman Sanders LLP. Jeanne E. Floyd (Jeanne.Floyd@troutmansanders.com), and Tania S. Sebastian (Tania.Sebastian@troutmansanders.com), are associates in the firm’s Richmond, and Tyson’s Corner, Virginia, offices, respectively. Blaine Aikin (Blaine@fi360.com), is chief executive officer of fi360. The views expressed in this article are those of the authors and do not necessarily reflect those of Troutman Saunders, fi360, or any of their clients or customers. The authors also would like to thank Stephen Stern, who is counsel with Thompson, Loss & Judge, LLP, and Troutman Sanders attorneys Evelyn S. Traub and Jimmy Rock for their contributions to the article.