ESG Trust Investments

Take-Away: Environmental impact, social factors, and governance may be viable investment philosophy for a trust to pursue, but it is not without controversy, especially in light of a trustee’s fiduciary duty of loyalty to trust beneficiaries.

Background: There is much discussion these days with regard to a trust investing with a focus on Environmental, Social and Governance, often referred to a ESG investing.  ESG reflects any investment strategy that considers environmental impact, social factors, and governance. ESG investing first appeared in the 1990’s with a proliferation of funds and offerings that catered to ‘socially responsible investments.’  The thought was that by following ESG factors, a trustee might identify better investments that offer better risk adjusted returns for the trust.

Debate: Despite the perceived growing popularity of ESG investing, it is not without some controversy.The controversy deals with collateral benefits that are associated with ESG investments, benefits to society in general, but not trust beneficiaries in particular. Collateral benefits are different from the normal risk/return analysis that trustees normally must follow when investing trust assets.

–Collateral Benefits: Some believe that ESG investing by trustees may include the collateral benefit of third parties, e.g. divest fossil fuel investments to improve the climate for everyone; the focus is on obtaining an investment return that uses ESG factors to divest from fossil fuels because they do not account from a shift away from carbon. Society as a whole benefits from this investment focus.

– Fiduciary Duty of Loyalty: However, the trust law’s duty of loyalty is a sole interest rule, by which the trustee must administer the trust solely in the interest of trust beneficiaries. [MCL 700.7802; MCL 700.1212.] A mixed motive by the trustee is prohibited. As such,  a trustee has a duty not to be influenced by any motives other than the purposes of the trust. This is not just some regulation; it is an absolute prohibition, where the trustee cannot have any motive of anything other than the pure motive to benefit  the trust beneficiaries. Consequently, some purists claim that the trustee cannot be distracted from the responsibility to the trust beneficiaries by the motivation to benefit environmental or social causes.

– Best Interests Standard: A variant of the trustee’s duty of loyalty is its obligation to meet the best interests test; the trustee must always act in the best interests of the trust beneficiaries. Along these lines the U.S. Supreme Court has held in connection with investments made with respect to an ERISA-governed qualified retirement plan that the trustee’s duty of loyalty relates solely to the financial benefits the trustee must seek on behalf of the plan participants. Thus, with regard to ERISA plans, ERISA requires complete fidelity to the financial interests of the plan participants with no possible motivation in favor of ESG factors, and qualifed plan documents cannot change background policy as interpretated by the Supreme Court for qualified plans. There may, though, be a bit more flexibilty with regard to personal trusts.

– Duty of Prudence: The Uniform Prudent Investor Rule and the Uniform Principal and Income Act require that the trustee invest as a prudent investor would. [MCL 700.1502(1).] The Prudent Investor Rule, though, a default rule that can be eliminated by the terms of the trust.  [MCL 700.1502(2).]  Yet ESG investing is a vague, subjective,  and individuals may differ on how each of the E, S, or G factors are to be weighed with respect to investment options. Thus,  it is hard to determine if ESG investing actually produces good investment results as each factor can be weighed differently. Examples: Is natural gas good under ESG or bad? Nuclear power good or bad? Alcohol? Gambling? It is hard to have an ESG investment mandate that is so variable and fluid, when it is subject to so many different and subjective points of view.

Personal Trusts: The question is whether a trust settlor can compel the trustee to consider ESG investments, despite the common law’s fiduciary duty of loyalty and notwithstanding the risks that may be associated with ESG investments. Presumably making ESG investments is not much different than a settlor’s direction to the trustee to retain a family business or a vacation home in the trust. If such an ESG investment directive is in a trust instrument, and the trustee is worried about violated the trustee’s fiduciary duty of loyalty to the trust beneficiaries, the trustee can always petition the probate court for directions if it is uncomfortable with the ESG mandate.

Beneficiaries Ask for ESG Investments: If a trust instrument is silent on ESG investments, but the trust beneficiaries want ESG investments held in the trust, the trustee will need to have all the trust beneficaries sign waivers, ratifications  and releases. [MCL 700.7909.] For a trustee to be fully protecting in adopting an ESG investment strategy for the trust, all current, remainder, and contingent beneficiaries will have to sign the waivers and releases, which may be a challenge due to conflicts of interest. Example: A current trust beneficiary may be totally in agreement to give up returns in exchange for ESG investments held in the trust, but trust remainder beneficiaries may not be happy taking on additional risks with ESG investments and possibly lower returns.

Delaware: Interestingly, Delaware has adopted  a statute that changes the trustee’s common law duty of loyalty. The Delaware statute provides that the terms of a trust that prescribe an ESG investment strategy will be enforced, even if it sacrifices returns. In effect, the Delaware statute authorizes a combination of a trust for its beneficiaries and also a specific purpose trust.

Conclusion: It is not always clear whether a trustee should use ESG factors to enhance investment returns or to obtain collateral benefits that third parties would experience. 

– A trustee’s duty of loyalty normally prohibits the trustee from making trust investments that provide collateral benefits to third-parties, e.g. members of society.

– However, a mandated ESG investment strategy might work with a charitable trust if the ESG strategy is consistent with the charity’s overriding purpose.

– A fiduciary’s prudence in making trust investments may permit ESG investments on the same terms as any other investment strategy, as each investment is looked at as part of the whole, but the ESG risk/return, while consistent with the trustee’s duty of loyalty, is not clearly consistent with the trustee’s duty of prudence in making trust investments.

– An ESG investment directive in a trust should probably be viewed in light of the trustee’s custom and practice when it is asked to deal with an investment diversification waiver in the trust instrument.