The Law and Economics of Environmental, Social, and Governance Investing by a Fiduciary

Max M. Schanzenbach is the Seigle Family Professor of Law at the Northwestern University Pritzker School of Law and Robert H. Sitkoff is the John L. Gray Professor of Law at Harvard Law School. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Social Responsibility Resolutions by Scott Hirst (discussed on the Forum here) and Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here).

Trustees and other fiduciary investment managers are under increasing pressure to consider environmental, social, and governance (“ESG”) factors in their investment decisions. For example, some charitable endowment managers, including those at Harvard and Stanford, face demands to divest from fossil fuel companies. Trustees and other fiduciaries of private trusts and pension funds face similar pressures to adopt ESG strategies. In a new working paper, we consider the law and economics of ESG investing by fiduciaries of private trusts, pensions, and charities.

ESG investing resists precise definition, but roughly speaking it is an umbrella term that refers to an investment strategy that emphasizes a firm’s governance structure and the social and environmental impacts of the firm’s products or practices. For example, an ESG investment strategy might avoid fossil fuel or tobacco companies as socially and environmentally irresponsible. An ESG strategy might also involve exercising shareholder rights to pressure managers to adopt environmental or labor-friendly policies.

Evidence of the salience of ESG investing abounds. In the words of Goldman Sachs, “ESG investing, once a sideline practice, has gone decisively mainstream.” In 2006, a group convened by the United Nations, the Principles for Responsible Investing (“PRI”), issued guidelines on ESG investing and called on investment firms to pledge adherence to them. Almost 2,000 asset managers have signed the statement, including many of the world’s leading institutional investors. The U.S. Department of Labor (“DOL”) has issued a series of bulletins, the most recent earlier this year, that provide guidance on ESG investing by a pension fiduciary.

ESG investing finds its roots in the socially responsible investing (“SRI”) movement that came to the fore in the 1980s as part of a divestment campaign aimed at South Africa’s apartheid regime. The motives for SRI were moral or ethical, based on third-party effects rather than investment returns. Such motives run afoul of the trust fiduciary duty of loyalty, which imposes a “sole interest rule” that requires a trustee to consider only the interests of the beneficiary, without regard for the interests of anyone else, whether the fiduciary personally or a third party.

In the late 1990s and early 2000s, however, proponents of SRI, now rebranded as ESG investing with the addition of governance factors (the “G” in “ESG”), began arguing that ESG investing could improve risk-adjusted returns. For example, instead of avoiding the fossil fuel industry to achieve collateral benefits from reduced pollution, the new suggestion was that a fossil fuel company should be divested because its litigation and regulatory risks were underestimated by its share price. On this view, ESG investing is a kind of active investment strategy that could satisfy the trust law prudent investor rule.

On the assumption that ESG investing improves risk-adjusted returns, an influential report sponsored by the PRI and prepared by Freshfields Bruckhaus Deringer argued that ESG strategies are consistent with fiduciary duty and, even more, that considering ESG factors “is arguably required in all jurisdictions.” In a 2015 follow up, the PRI took the position that not only is ESG investing consistent with fiduciary law but “there are positive duties on investors to integrate ESG issues.” Nonetheless, many fiduciaries continue to express skepticism about the permissibility of ESG strategies, perhaps owing to their association with what was formerly called SRI.

The primary contributions of our paper are three. First, we clarify ESG investing by organizing it into two categories. We refer to ESG investing for moral or ethical reasons or to benefit a third party as collateral benefits ESG, and ESG investing to improve risk-adjusted returns as risk-return ESG. Based on this taxonomic clarity, we show that ESG investing is permissible by a trustee or other fiduciary of a private trust, pension, or charitable endowment only if: (1) the fiduciary believes in good faith that the ESG investment program will benefit the beneficiary directly by improving risk-adjusted return, and (2) the fiduciary’s exclusive motive for adopting the ESG investment program is to obtain this direct benefit. We show, in other words, that risk-return ESG can be consistent with fiduciary duty but is not required by it, and collateral benefits ESG is generally not consistent with fiduciary duty.

Second, because so much of the debate has centered on the claim that ESG investing can provide superior risk-adjusted returns, we undertake a balanced assessment of the current theory and empirical evidence on that question. We conclude that there is indeed theory and evidence in support of risk-return ESG. However, this support is far from uniform, is often contextual, and in all events is subject to change, especially as markets adjust to the growing use of ESG factors. Proponents of risk-return ESG have exaggerated its potential to generate excess risk-adjusted returns, have confused evidence of a factor’s relationship to firm performance with evidence of market mispricing, and they have failed to appreciate the instability and lack of robustness in academic findings of asset mispricing.

Because risk-return ESG is an active investment strategy meant to improve returns, the same conceptual logic that motivates it could alternatively support a contrarian, anti-ESG investment strategy. Thus, if a fiduciary reasonably concludes that securities prices overcompensate for ESG factors, the fiduciary may take the opposite bet. Or a fiduciary could reasonably conclude that she cannot beat the market and therefore should invest in a broad, passive fund. In short, fiduciary investment principles neither favor nor disfavor risk-return ESG.

Third, we improve on the prior generation’s analysis of SRI, what we call collateral benefits ESG, by analogizing pursuit of collateral benefits to a distribution for the same purpose. The payoffs to this analogy include traction on the muddled questions of collateral benefits ESG by a charitable endowment or in a private trust with settlor or beneficiary authorization. In brief, if a fiduciary could not make a distribution for an ESG purpose, the fiduciary may not pursue that purpose via the fiduciary’s investment program. Put otherwise, to the extent a fiduciary could make a distribution for an ESG purpose, that purpose is not “collateral,” and may be pursued likewise via the investment program.

Our analysis is in general agreement with the DOL bulletins, but improves on them in two ways. First, by differentiating between collateral benefits ESG and risk-return ESG, and by drawing on the latest evidence from financial economics, our analysis is clearer, more specific, and better grounded in law and economics. Second, we correct the DOL’s error in endorsing use of collateral benefits as a tie breaker between two equivalent investments. We show that this position is contrary to textbook financial economics as well as Supreme Court precedent interpreting the controlling federal statute.

Our analysis challenges the current zeitgeist in favor of the soundness of ESG investing by a fiduciary, in particular many of the arguments advanced by the PRI. However, we also show that knee-jerk reactions against ESG investing on loyalty grounds are likewise misguided, reflecting a kind of SRI hangover. Fiduciaries who reasonably conclude that ESG factors will improve portfolio performance, and are solely motivated by this possibility, should have no hesitation in using them.

The complete paper is available here.

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One Comment

  1. michael
    Posted Thursday, September 20, 2018 at 1:51 pm | Permalink

    In the valuation of ESG returns, I suspect, but have not tried to confirm, that positive ESG investment returns are skewed by the 10+ year performance return by the FANG stocks. If those stocks were deleted from both ESG and non-ESG related return calculations, I wonder how ESG stocks would fare in the comparison. Or to say it otherwise, I suspect the last 10 years will be seen in retrospect as a atypical “moment” of outsized ESG returns.