Advocates for sustainable and ESG investing are hoping the United Nations Intergovernmental Panel on Climate Change report will serve as a wakeup call. The report, released on Aug. 9, 2021, offered a stark picture about the realities of climate change, and was described as a "code red for humanity" by the U.N. Forum for Sustainable and Responsible Investment. Governmental action will be key to tackling the climate crisis. The report also sees a large role for financial services in including ESG factors in investment decisions. Some have taken the position that trustees of pensions, charities and private trusts must include ESG factors in investing. Others have taken the position that using ESG factors in investing, specifically violates a fiduciary’s duty of loyalty to their beneficiary. So, as we draft, fund and manage pensions, charities and private trusts, how do we include ESG factors without violating fiduciary duties?
A trustee is personally liable for a breach of his or her fiduciary duties. The trustee’s fiduciary duties include a duty of loyalty and a duty of prudence. The duty of loyalty requires that the trustee administer the trust solely in the interest of the beneficiaries. The duty of prudence requires that the trustee is held to an objective standard of care in managing the trust property. Combined, the duty of loyalty and of prudence requires the trustee to invest the assets only for the benefit of the trust’s beneficiaries. Although under the Uniform Prudent Investor Act a fiduciary can delegate the execution of the investment management to an investment management firm, he or she cannot avoid personal liability for any loss due to an investment made that is not strictly for the sole benefit of the trust’s beneficiaries.
ESG is an investment policy reflecting responsible environmental, social and governance practices. It originated with the socially responsible investing movement of the 1980s directed towards the apartheid regime of South Africa. This included investment decisions based on the moral, ethical or social factors on the actual or inferred effects of investments on third parties, which have only indirect effects on the actual beneficiaries the fiduciary owes a duty towards. Corporate governance was added to this list, based on the argument that good governance necessarily means better risk-adjusted returns. When activists lobby endowments to divest from fossil fuel industries, they do so on the assumption that, as a class, fossil fuel industries’ prices are not reflective of the increased litigation and regulatory risks, and, so is consistent with the sole interest duty owed to beneficiaries. This position has been taken further by some, such as in the 2015 U.N. report, that fiduciaries have an affirmative duty to integrate ESG factors into all of their investments.
Some of the confusion lies in which ESG factors in investing a fiduciary should consider. Factors that directly benefit a beneficiary of the trust are allowed, but not factors that benefit a third party based on a moral or ethical basis, and only indirectly benefit the trust beneficiaries. The assumption that an ESG investment will always outperform a non ESG investment alone can’t justify prioritizing ESG factors. More is required when drafting trusts and other documents.
Setting the investment policy for a pension, endowment or private trust requires an active investment policy where the ESG factors are only considered when deciding between equally good investments. For example, if you have an investment policy to pursue an active growth investment strategy, and there are two equally good growth investments, one in fossil fuel industries and one in renewable energy industries, it would be permissible for the fiduciary to pick the ESG investment over the equally good non-ESG investment. The key in making this decision is the active investment management of the endowment or portfolio that focuses on the risk adjusted return to the beneficiaries first and ESG factors second.
Nick Cantrell, the founder and wealth advisor of Green Future Wealth Management, has experience in integrating ESG factors into investment management. When asked about integrating ESG factors into advising fiduciaries his response is:
“As a fiduciary providing asset management for trust accounts that incorporate ESG investing, we are careful to not only ensure that the investments we recommend meet the ethical mandate of the trust, but that we can also identify specific pecuniary benefits to the inclusion of the ESG investment options. Fiduciaries should always be able to justify their investment selection, but I think that this is extremely important when dealing with ESG investments within a trust or charity. Trustees or Directors looking to include ESG investments should work with a qualified fiduciary who specializes in ESG investing, ideally possessing the CSRI designation, which signifies that they have completed a rigorous ESG investment curriculum.”
For charities, ESG factors are permitted in making “program related” investments including indirect or collateral benefits to the charity. This includes making direct investments in communities with a lower risk adjusted return than investments in publicly traded securities would yield.
Pensions, however, are bound by federal laws, and even if there is a strong desire to include ESG factors investments, the fiduciary cannot do so without the risk of break of their fiduciary duty.
As fiduciaries we wish to do the right thing when it comes to including environmental, social and governance factors in making investment decisions. Fiduciaries, however, do not have that freedom as they are held strictly accountable for any losses under the duty of loyalty and prudence in their investment decision. It’s important to specify the preference to prioritize ESG factors as part of your fiduciaries’ investment process, allowing him/her to make sustainable investment choices without fear of personal liability.
Matthew Erskine is managing partner at Erskine & Erskine.
