Fiduciaries manage significant assets held in university endowments, pension funds, charitable foundations, and private trusts. These fiduciaries have a duty of loyalty to the purposes and beneficiaries they serve and must comply with the prudent investor standard in making investment decisions. As interest in using environmental, social, and governance (ESG) factors in investment decision making has grown, some fiduciaries have wondered whether they can engage in ESG investing without breaching fiduciary duties.
My working paper, Values and Value: University Endowments, Fiduciary Duties, and ESG Investing, explains that a fiduciary can incorporate material ESG factors into an investment strategy that combines traditional financial factors with non-traditional ESG factors without breaching the fiduciary’s duties of loyalty or care (prudence). The prudent investor standard has evolved to encompass the use of ESG investing, defined as an investment strategy that integrates material ESG factors with traditional financial data. The working paper focuses on university endowments, but the analysis applies to investment decision making by any fiduciary.
The questions about ESG investing and fiduciary duties developed in connection with earlier investment strategies often called socially responsible investing (SRI). SRI gained attention during the anti-apartheid era when SRI meant avoiding investments in companies that did business in South Africa or excluding “sin stocks” – companies involved in tobacco, alcohol, guns, or gambling. SRI strategies expanded beyond these negative screens to include best-in-class positive screens and shareholder advocacy through proxy voting, but the idea that SRI involves removing categories of stocks from a portfolio persists.
In contrast with early SRI, ESG investing takes a more nuanced and integrated approach. ESG investing, also called ESG integration, uses material ESG factors together with traditional financial tools to provide a more in-depth understanding of companies’ strengths and weaknesses. While traditional financial data can give analysts useful information about current market position and short-term prospects, ESG factors may identify risks or opportunities that will affect long-term financial performance.
Fiduciaries must comply with the prudent investor standard, a standard that has evolved over time. After its first appearance in 1830, the standard grew increasingly conservative during the 19th and early 20th century. With the development of modern portfolio theory (MPT) in the mid-20th century, the standard shifted to embrace MPT. The Uniform Prudent Investor Act, based on MPT and promulgated in 1994, included diversification as a central component of prudent behavior. Thus, an assumption developed that an investment strategy that imposed negative screens on a portfolio could not be prudent because restricting diversification would lead to lower returns.
The assumption that SRI necessitated a cost to a portfolio became commonplace. An official comment to the Uniform Prudent Investor Act states this assumption in connection with an admonition that a fiduciary that engaged in SRI might breach the duty of loyalty. The comment says:
No form of so-called “social investing” is consistent with the duty of loyalty if the investment activity entails sacrificing the interests of trust beneficiaries—for example, by accepting below-market returns—in favor of the interests of the persons supposedly benefitted by pursuing the particular social cause.
The comment reflects the concern that SRI would necessarily result in lower returns and would therefore violate the duty of loyalty, a fiduciary duty that requires trustees to put the interests of the beneficiaries first.
The acceptance of below-market returns does not violate the duty of loyalty if the investment relates to the non-financial interests of the beneficiaries. For a charity, an investment related to the charity’s mission complies with the duty of loyalty even if the financial returns are lower than those of another investment. The IRS recently issued Notice 2015-62, confirming that a private foundation that engages in mission-related investing will not be considered to be making jeopardizing investments, even if the mission-related investments do not maximize financial return. The charity can invest for both mission and financial return, as long as the charity follows “ordinary business care and prudence” in making the investments.
For many fiduciaries, ESG investing will not relate directly to mission, so the analysis of whether ESG investing violates the duty of loyalty depends on whether this sort of investment necessarily results in lower returns. At the time UPIA was promulgated, little empirical work had been conducted comparing the performance of SRI and non-SRI funds. Thus, an assumption that SRI caused lower returns could go unchallenged. In the years since 1994 a growing number of studies have demonstrated that SRI funds (defined variously in different studies) perform as well or better than non-SRI funds. The conclusion a fiduciary can draw from these studies is that a decision to incorporate ESG factors into an investment strategy does not necessitate a cost to the portfolio.
The studies demonstrate the absence of a cost, especially in connection with ESG investing as compared with screening strategies. The studies also show the value for those engaged in corporate governance of reporting about a company’s ESG information. The working paper discusses a number of the most recent studies, more than will be included here, but a few studies of particular interest in connection with corporate governance are described next.
A 2012 meta-study produced by Deutsche Bank examined more than 100 academic studies, 50 research papers, and four meta-studies and found that companies with higher ratings in corporate social responsibility (CSR) and in ESG factors had, when compared with companies with lower ratings, a lower cost of capital, both debt and equity. The higher-rated companies also showed overperformance in corporate financial performance.
Another study compared groups of high sustainability companies (companies that had “voluntarily integrated social and environmental issues in their business models and daily operations” by 1993) with low sustainability companies. The researchers found, among other results, that the high sustainability companies outperformed in both stock market performance and accounting performance.
These studies and others may explain increasing market interest in ESG disclosure. A study designed to examine that market interest analyzed “hits” accessing nonfinancial metrics in the Bloomberg database during three bimonthly periods in late 2010 and early 2011. The authors of the study hypothesize that financial analysts are interested in transparency concerning ESG performance and policies. Yet another study suggests that transparency and governance information are being used as proxies for good management.
The studies provide two types of information: data that show that ESG investing does not necessitate a cost to a portfolio and data that show that financial analysts increasingly use ESG factors in making investment decisions. My conclusion, after a review of these studies, an examination of the evolution of the prudent investor standard, and an understanding of ESG investing as a strategy that differs from negative screens, is that a fiduciary can engage in ESG investing without breaching the duty of loyalty or the duty of care.
A fiduciary managing investment assets should establish an investment policy with a level of risk appropriate to the purposes of the organization or the interests of the beneficiaries and then act as a prudent investor in making investment decisions. A prudent investor uses traditional financial tools and may also use non-traditional ESG factors. A fiduciary can use benchmarks to track financial performance, and as the Supreme Court recently reminded fiduciaries, a fiduciary has an ongoing duty to monitor investments. The prudent investor standard has evolved to include ESG investing as a strategy a prudent investor can consider, and because ESG investing does not necessitate a financial cost to the portfolio, ESG investing does not breach the duty of loyalty.
 Harvard v. Amory, 26 Mass. (9 Pick.) 446 (1830).
 Unif. Prudent Investor Act § 5 cmt. (1994).
 For a discussion focused on mission-related investing see Susan N. Gary, Is It Prudent to be Responsible: The Legal Rules for Charities that Engage in Socially Responsible Investing and Mission Investing, 6 Nw. J.L. & Soc. Pol’y 106 (2011).
 These studies compare managed funds with managed funds, and do not compare the results with unmanaged index funds.
 Sustainable Investing/Establishing Long-term Value and Performance, Deutsche Bank Group (2012).
 Robert G. Eccles, Ioannis Ioannou, & George Serafeim, The Impact of Corporate Sustainability on Organizational Processes and Performance, Social Science Research Network (Mar. 1, 2013) http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1507874.
 Id. at 2.
 Robert G. Eccles, Michael P. Krzus, & George Serafeim, Market Interest in Nonfinancial Information, (Harv. Bus. School, Working Paper 12-018 at 1, 2011).
 See Demystifying Responsible Investment Performance, The Asset Management Working Group of the United Nations Environment Programme Finance Initiative and Mercer (Oct. 2007),
 Tibble v. Edison Internat’l, 135 S Ct. 1823 (May 18, 2015).
The preceding post comes to us from Susan N. Gary, the, Orlando J. and Marian H. Hollis Professor of Law at the University of Oregon. Professor Gary served as the Reporter for the Uniform Prudent Management of Institutional Funds Act. The preceding post is based on Professor Gary’s article, which is entitled “Values and Value: University Endowments, Fiduciary Duties, and ESG Investing” and available here.