As many now know, environmental, social and governance (ESG) investing is clearly a thing.1 As of December 2021, assets in U.S. sustainable funds totaled $357 billion.2 New flows to those funds in 2021 were $71 billion, easily outpacing 2020’s previous record flows of $51 billion.3
For trustees, the interest in ESG investing presents a quandary.4 Beneficiaries, grantors, investment managers and other advisors, as well as the trustee’s own views, may motivate a trustee to explore ESG investing. Yet depending on the trustee’s approach, a trustee’s fiduciary duties may restrict their ability to act on their increasingly common intentions.
Fiduciary Duties
In general, a trustee under the prudent investor rule (PIR) must consider many factors in developing an overall investment strategy for the trust. These considerations include the trustee’s duty to diversify, general economic conditions, inflation and deflation, tax consequences, liquidity needs and other purposes of the trust.5
In addition, a trustee has duties outside the PIR that may affect their investment activity. These typically include duties:
- to administer a trust in accordance with the terms of the trust instrument and applicable law;
- to act solely in the interests of the trust’s beneficiaries;
- to deal impartially with the trust’s beneficiaries;
- not to use or deal with the trust property for the trustee’s own profit or other purpose unconnected with the trust; and
- to keep the beneficiaries informed of the trust administration.
In response to this web of interrelated duties, Professors Robert H. Sitkoff of Harvard Law School and Max M. Schanzenbach of Northwestern University School of Law have provided an essential framework for trustees considering ESG investing.6 By asking the simple question of why a trustee engages in ESG investing, Sitkoff and Schanzenbach have constructed a two category taxonomy of ESG investing by a trustee:
- Collateral benefits ESG investing is “motivated by providing a benefit to a third party or otherwise for moral or ethical purposes.”
- Risk-return ESG investing is “to improve risk-adjusted returns.”7
Under general trust law, collateral benefits ESG investing is a breach of trust because, by definition, it involves considerations other than the sole interests of the beneficiaries and the terms of the trust.8 On the other hand, risk-return ESG investing can align with a trustee’s responsibilities, because improving risk-adjusted returns conforms to the PIR.
The trustee engaged in risk-return ESG investing remains subject to the PIR’s standard of care.9 As with any other active investment strategy, the trustee must reach a reasonable conclusion that: (1) the ESG investing strategy would result in returns that would offset the risks and costs; and (2) the trustee can credibly execute on the strategy.10 A trustee must also address the requirements of ongoing monitoring, recordkeeping, communication and adjustments if the strategy doesn’t perform as intended.11
Sitkoff/Schanzenbach’s Framework
Sitkoff and Schanzenbach’s framework clarifies what’s necessary for a trustee to consider ESG investing. If a trustee is motivated solely by their own desire to make the world a better place, they should stop. That’s collateral benefits ESG investing and a de facto breach of trust. If a trustee is motivated by a beneficiary’s or the settlor’s desire to make the world a better place, the same is true absent a modification of the trustee’s duties. But if a trustee is motivated by risk-return analysis, they can clear the hurdle of motivation and focus on the standard of care that applies to investment strategies generally.
Of course, a trustee’s motivations may not be so clear. In cases of mixed or muddled motivation, Sitkoff and Schanzenbach’s framework remains essential by driving the trustee to ask a series of questions.
What’s the ESG strategy? Today, we may be familiar enough with ESG investing to know it when we see it, but it’s still amorphous enough not to know what we’ll see until it’s there. The spectrum of potential ESG investment strategies ranges from negative screening to integrative techniques to various forms of impact investing. See “ESG Investor’s Toolkit,” this page.These strategies apply to an even broader range of different ESG themes or areas of concerns (for example, climate change, economic justice, diversity, equity and inclusion and tax practices). Until you identify a specific strategy, it’s impossible to clarify the motivation behind a trustee’s ESG investing.
Who’s the source of the ESG strategy? If the trustee is the source, the trustee can simply consider if they’re using the ESG strategy to improve the trust’s risk-adjusted returns or for another purpose. If the source is a beneficiary or settlor, the trustee still needs to focus on their own risk-return analysis. But the beneficiaries’ and settlor’s interests create collateral concerns that also require the trustee’s attention. Identifying the source of the ESG strategy may also highlight who isn’t expressing an interest or included in the conversation.
What’s the ultimate motivation to implement the ESG strategy? A trustee may have a mix of motivations. But the trustee should avoid muddled motivations. The trustee should isolate each motivation, order them in terms of supporting or contradicting engagement in the strategy and then determine what’s the “but for” motivation that would push the trustee to engage in the strategy. Especially if a trustee is balancing a mix of motivations, putting numbers on their expectations and acceptable results can be critical. See “Trustee Decision Tree,” this page.
Example. Consider a situation in which the beneficiaries of a trust ask the trustee not to invest in energy companies unless they’re making significant investments in renewable energy. First, the trustee needs to clarify the proposed strategy. Is it to screen out certain companies or to include certain companies while screening out the energy sector? What qualifies as “significant investments”? What qualifies as “renewable”? The source of the strategy is the beneficiaries, but it’s worth determining what the settlor and any other parties think. The trustee also needs to determine what they think. If the trustee’s risk-return analysis is negative, the beneficiaries’ request would clearly be the trustee’s ultimate motivation, and the trustee needs to address how the negative analysis reconciles with their fiduciary duties. If the trustee’s risk-return analysis is positive, the beneficiaries’ interest still may be the factor persuading the trustee to engage in the strategy. Alternatively, the risk-return analysis alone could be enough to persuade the trustee, and they need to clarify that the beneficiaries’ position didn’t matter.
Different Types of Trustees
As the example above illustrates, depending on the specific ESG strategy, trustees may find themselves in a range of positions when they line up their motivation with the proposed strategy and Sitkoff and Schanzenbach’s categories of collateral benefits ESG investing and risk-return ESG investing. Although not exhaustive of the possibilities, trustees will likely find themselves in one of four categories in relation to any particular strategy:
ESG-convicted trustee who selects an ESG strategy as the best approach for the trust based solely on their risk-return analysis.
ESG-willing trustee who views an ESG strategy as a potential option based on their risk-return analysis and would select it based on the beneficiary or settlor’s request.
ESG-persuaded trustee who views an ESG strategy as an ambivalent option based on their risk-return analysis but would select it based on the beneficiary’s or settlor’s request.
ESG-compelled trustee who views an ESG strategy as sacrificing returns but would select it based on the beneficiary’s or settlor’s demand.
Drafting Tips
Assuming the trustee wants to proceed with an ESG strategy, each of these situations presents different considerations in drafting the documents to support the trustee’s position. The trustee needs to determine if there should be special provisions in the trust instrument or any beneficiary releases, along with the related questions of where to locate the trust and what’s the governing law for trust administration. The trustee also needs to determine how to incorporate the ESG strategy into their investment policy statement (IPS) and possibly an ESG strategy statement (ESS) outlining the strategy in more detail.
ESG-convicted trustee. Tips to consider:
No need for special provisions.The ESG-convicted trustee is engaged in risk-return ESG investing. As a result, there’s no need to alter the trustee’s fiduciary duties. In fact, if there’s a special provision in the trust instrument, the trustee should clarify they aren’t relying on it. Similarly, even if the beneficiaries are willing, a beneficiary release may imply a muddled or mixed motivation when that’s not the case. Special provisions also may not be necessary in an IPS because trustees and investment managers often don’t provide granular detail on their specific investment strategies.
Descriptions may be useful. A concrete description of the ESG strategy, though, may also be helpful if the parties to the trust are likely to show an interest, positive or negative, in the strategy. If there’s a description of the ESG strategy in the IPS, it should be placed in the implementation section. This is as opposed to the background or investment parameters sections, which would imply the strategy is being chosen as a requirement rather than a result of the trustee’s risk-return analysis.
An ESS could be appropriate if the trustee wants to go further into detail on the ESG strategy. A robust ESS may include sections on: (1) the relevant ESG investing landscape; (2) definitions of key terms; (3) identification of viable implementation strategies within the relevant landscape; (4) a mission statement of the trust; (5) a description connecting the mission statement to the viable implementation strategies to be pursued; (6) guidelines for the investment objectives within those strategies; (7) standards for evaluations; and (8) timeframes for review specific to the strategy. The mission statement is typically the centerpiece of an ESS. An ESG-convicted trustee should be sure to tie their mission statement to their focus on risk-return analysis.
ESG-willing trustee. Tips to consider:
Acknowledge the both/and situation. The trap for the ESG-willing trustee is avoiding the obvious and pretending they’re an ESG-convicted trustee when that’s not the case. Instead, the ESG-willing trustee should focus on how they can acknowledge both their positive risk-return analysis of the strategy and the beneficiary or settlor support leading them to select it over other acceptable options.
Currently, five states—Delaware, Georgia, Illinois, New Hampshire and Oregon—have laws that may support acknowledgment of this both/and situation.12 Delaware Code Section 3303 provides a trust instrument may vary the laws of how a trustee invests, “including whether to engage in 1 or more sustainable or socially responsible investment strategies, in addition to, or in place of, other investment strategies, with or without regard to investment performance.” Similarly, Delaware Code Section 3302 includes among the factors a trustee may consider in making investment decisions, “the beneficiaries’ personal values, including the beneficiaries’ desire to engage in sustainable investing strategies that align with the beneficiaries’ social, environmental, governance or other values or beliefs of the beneficiaries.”
These provisions enable an ESG-willing trustee to reflect the reality of their situation. If a trust is in Delaware and includes a provision explicitly supporting consideration of ESG strategies, the trustee could draft an IPS that both states that fact as part of the background of the trust and explains the selection of the ESG strategy as based on both the trustee’s risk-return analysis with the trust terms’ added support. The IPS should make clear that, while selected in part due to the trust instrument’s support, the strategy is still being judged by standard benchmarks. Because the trustee’s risk-return analysis supports the ESG strategy, the provision in the trust instrument may simply permit (rather than require) consideration of ESG strategies.
Confirm beneficiary support and method of ongoing evaluation. If a trust is already in existence and can’t be modified to include authorization by the settlor, Section 3302 might be relied on to the same result if the support is coming from the beneficiaries. The trustee should also consider a separate beneficiary release to confirm the connection between the beneficiaries’ values and the specific ESG strategy.
For the ESG-willing trustee, an ESS can be a tool to further define the ESG strategy as well as clarify the balance between the trust instrument or beneficiary support and the trustee’s risk-return analysis in the ongoing monitoring and evaluation of the strategy. Assuming the strategy is judged by standard benchmarks, the trustee should clarify the extent to which other factors may influence the strategy’s evaluation and what are the numerical parameters. The mission statement, like the IPS, should acknowledge both the trust instrument or beneficiary support and the trustee’s risk-return analysis as relevant concerns.
ESG-persuaded trustee. Tips to consider:
Define ambivalence and address fiduciary duties. The ESG-persuaded trustee is engaged in collateral benefits ESG investing. As a result, their primary concern should be how they’ll address the fiduciary duties that engaging in the ESG strategy would otherwise stand to breach.
As a first step, the ESG-persuaded trustee needs to define the ambivalence of their risk-return analysis. Their best starting place is with the IPS or an ESS. The trustee should isolate the negative conclusions of their risk-return analysis and how the beneficiary or settlor demand addresses them. Providing a concrete description of the strategy, specifying how the trustee will implement and monitor it and setting forth a framework for when changes would be made all will aid in this effort.
In many cases, the trustees may realize they’re relying more, or less, on the beneficiary or settlor than they initially thought. Often, the ESG-persuaded trustee is an ESG-willing trustee or an ESG-compelled trustee who simply has yet to figure it out. It can be useful to ask to what extent the trustee would tolerate divergence from standard benchmarks over the long term. The answer to that question typically can sort the ESG-persuaded trustee to either an ESG-willing trustee or an ESG-compelled trustee and enable them to turn to the trust instrument and beneficiary releases to try to address the limits and protections they need in relation to their fiduciary duties, as appropriate.
Reliance on state law support can be critical. For the ESG-persuaded trustee that doesn’t sort themselves to another category, statutes like Delaware Code Sections 3303 and 3302 can be critical. Ideally, the trustee has a provision in the trust instrument to rely on to engage in the ESG strategy. Permissive language encouraging the trustee to consider ESG strategies or beneficiary values (as in Section 3302) is likely insufficient if the trustee’s risk-return analysis of the strategy is negative or ambivalent. As Sitkoff and Schanzenbach have noted, absent a mandatory requirement to pursue an ESG strategy, a trustee still needs to consider the best interests of the beneficiaries, and a prudent trustee shouldn’t sacrifice those interests without direction from the court.13
If a trust is already in existence and can’t be modified, beneficiary releases become the imperative. But as Sitkoff and Schanzenbach have explained, there are practical limitations.14 A trustee generally must obtain releases from all potentially affected beneficiaries. This includes minor or unborn future beneficiaries, who could require appointment of a guardian ad litem or other representative. In addition, prospective authorizations or consents can only apply for so long. From a drafting perspective, the more specific an authorization, the clearer the release; but specificity is also a limit if the nature of a transaction shifts.
ESG-compelled trustee. Tips to consider:
Need to address fiduciary duties. From a drafting perspective, the difference between an ESG-compelled trustee and an ESG-persuaded trustee is simply they don’t need the preliminary exercise of determining how much they’re relying on the beneficiary or settlor. They know they are, entirely. As a result, they can focus straight away on how they can address their fiduciary duties.
Careful alignment of all documents. An ESG-compelled trustee acts at their own peril, unless there’s a clear trust provision mandating their engagement in the ESG strategy. In addition, a beneficiary release is strongly advisable to confirm alignment of the strategy with the trust terms and the beneficiaries’ support, ideally, as validated by a statute like Delaware Code Section 3302.
Moreover, the IPS and any ESS also need careful attention to ensure they align with each other, the trust instrument and beneficiary release. Now in the opposite situation of the ESG-convicted trustee, the mandate for the ESG strategy should be part of the background section of the IPS. While the mandate should flow through to the requirements of implementation, monitoring and adjustments, the trustee risks confusing their reliance on the trust instrument or beneficiary release if it appears the trustee is selecting the strategy based on their own analysis.
If there’s a gap between the mandate from the trust instrument and the specific ESG strategy to be employed, an ESS could be essential to define the relevant landscape, viable strategies and rationale for selecting the strategy to be employed as guided by the trust instrument and beneficiary releases. Again, it can be crucial for the trustee to define in concrete terms the expectations for the strategy in relation to standard benchmarks and the other goals motivating the investment.
Picking a Strategy
Absent solving the world’s ills, the trend toward ESG investing is likely to continue. Similarly, trusts—in many cases by their own terms—are here for generations to come. Inevitably, trustees will need to decide what they think of the various ESG strategies that arise.
A trustee may be ESG-convicted as to some strategies, ESG-willing to others and ESG-compelled as to others still. See “Four Categories,” this page. If trustees can be clear on their analysis and motivations for different strategies as Sitkoff and Schanzenbach’s framework demands, they have an opportunity both to guide the field of ESG investing and help other trustees as they try to navigate what trust beneficiaries, settlors and the law demand.
Endnotes
1. In this article, we use the term “ESG investing” to refer to investment activity involving consideration of environmental, social and governance factors. The term is intended to include what might also be called socially responsible investing, sustainable investing, values-based investing or impact investing.
2. www.morningstar.com/articles/1075161/us-fund-flows-smashed-records-in-2021.
3. Ibid.
4. In this article, our focus is on trustees of personal, non-charitable irrevocable trusts governed by the laws of a U.S. state. While this article may provide insight for trustees and other fiduciaries in different contexts, we haven’t attempted to address the range of circumstances that may apply to all fiduciaries.
5. Uniform Prudent Investor Act Sections 2 and 3 (1995).
6. Max M. Schanzenbach and Robert H. Sitkoff, Fiduciary Duty, Social Conscience, and ESG Investing by a Trustee (Oct. 18, 2021), Chapter 9, in 55 Annual Heckerling Institute on Estate Planning (2021) (Sitkoff and Schanzenbach), which is based on Max M. Schanzenbach and Robert H. Sitkoff, “Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee,” 72 Stan. L. Rev. 381 (2020). For a more concise summary, see Max M. Schanzenbach and Robert H. Sitkoff, “ESG Investing: Theory, Evidence, and Fiduciary Principles,” Journal of Financial Planning (October 2020), at p. 46.
7. Sitkoff and Schanzenbach, para. 901.4, 9-14.
8. Sitkoff and Schanzenbach, para. 904.2, 9-27.
9. Sitkoff and Schanzenbach, para. 906, 9-38 to 9-48.
10. Sitkoff and Schanzenbach, para. 906.1, 9-40 to 9-41.
11. Sitkoff and Schanzenbach, para. 906.1, 9-41 to 9-42.
12. See Oregon Revised Statutes Sections 130.020 and 130.755; Illinois Trust Code Section 902; New Hampshire Trust Code Section 564-B:9-902(c)(10); Georgia Code Section 53-12-340.
13. Sitkoff and Schanzenbach, para. 904.3, 9-30 to 9-31.
14. Sitkoff and Schanzenbach, para. 904.4, 9-32 to 9-34.