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.