Carol V. Calhoun, Shareholder Calhoun Law Group, P.C. 9112 Lindale Drive Bethesda, MD 20817-3441 Office Phone: (202) 441-5592 Telefax: (301) 564-1941 E-mail: Click here to send e-mail.

In recent years, many fiduciaries of pension funds and other institutional investors have considered whether they can take into account social concerns, or economic considerations other than pure financial return, along with financial risk and return in making investments for the funds. At the same time, the ongoing debate on whether some portion of the Social Security trust fund should be invested in the stock market has heightened the controversy about such policies. Several Members of Congress have claimed that state retirement systems have pursued social concerns to the detriment of their participants' financial interests, and have used such claims to argue against investment of Social Security funds in the stock market. The publicity on this issue has caused a renewed focus on socially screened investments by other types of institutional investors, as well as state retirement systems.

The focus of this presentation is on the legal constraints that may apply to various types of pension funds and other institutional investors in implementing a socially screened or economically targeted investment policy.

Background

1. Definition of Social Investing

A fiduciary has a responsibility to manage investments for the exclusive benefit of the parties toward whom its fiduciary duties run. The question is whether, and to what extent, it may consider the social consequences of its investments when it provides a collateral benefit to a prudent investment process.

One of the problems in analyzing this issue is that "social investing" has been used by a variety of people to mean a variety of things. For example, each of the following has been considered by at least some people to be social investing:

• Economically targeted investments. These are investments chosen to foster specific social goals, such as economic development and/or home ownership in a particular state or area.
• Shareholder activism. This involves using the ownership rights associated with equity holdings to influence the behavior of individual firms. Often, fiduciaries have intended shareholder activism to increase the value of shares owned by changing management practices. The only instance in which shareholder activism becomes social investing is when it is used to foster other goals. For example, a number of states have passed laws addressing the "MacBride Principles," a set of policies aimed at ending religious discrimination in Northern Ireland.
• Preferences for certain investment managers (e.g., a preference for minority- or female-owned investment firms). This practice does not directly affect what investments a fund makes. Rather, it affects investment performance only insofar as the chosen managers choose different investments than other investment managers might choose.
• Socially screened investments. For example, many church pension funds will limit new investments in companies that produce products in conflict with the particular denomination's beliefs. This screening commonly involves companies that produce tobacco products, alcoholic beverages, pornography, or which conduct gambling operations, but could also extend to restrictions on investing in the defense industry or even certain food producers (e.g., meat or caffeinated products) in the case of churches that promote certain dietary restrictions.
• Divestiture. At first, this involved selling stocks in companies that invested in South Africa, a practice that changes in the South African political situation have eliminated in recent years. However, it has also been proposed in other areas, although it is not, at least as yet, in common use.

Clearly, there are immense practical differences among the various strategies. Nevertheless, the legal principles guiding each of these types of investing have been the same, although their application has varied depending on the factual situation.

2. History of Social Investing

Over the past twenty years, a number of individual and institutional investors have begun considering the social consequences of their investment strategies. For example, thirteen states have at one point had some sort of limitation or ban on investment in South Africa by state pension funds. Although these bans were repealed after the fall of apartheid, a variety of other social investing strategies are still in effect. For example, as of 1995, legislation in six states provided for some sort of use of state pension investment strategy to oppose religious discrimination in Northern Ireland. Other states restricted investment in Iran, Cuba, or companies which complied with the Arab League's boycott of Israel.

Policies concerning social investing have commonly been based on one of two theories. The first is that avoiding certain types of investments (e.g., investment in companies which did business in South Africa) was prudent, because the unsettled political situation made companies which did business there inherently more risky than those which did not. The second was that society as a whole benefited if each investor used its financial power not only to make profits for itself, but to further social goals.

The first theory has not been controversial. No one would question the right of a pension fund to avoid, for example, investment in tobacco stocks based on the trustees' reasonable belief that the risks associated with tobacco stocks, in relationship to their returns, make them a poor investment.

The second theory has generated much more controversy, since it impliedly involves a trade-off under which the potential investment returns for an individual might suffer at least to some extent in order to benefit the rest of society. While no one has questioned the right of individuals to make such trade-offs in their private affairs, questions have arisen as to whether a fiduciary charged with managing assets held for the beneficial ownership of others is entitled to make such a trade-off on their behalf.

Contexts in Which Issue Arises

Investment managers have considered the social impact of their investments in two contexts. First, to what extent does the controversy surrounding certain industries cause stocks of companies in those industries to be riskier, relative to their potential return, than other available investments? For example, to what extent can a fiduciary which is considering the prudence of investing in a tobacco-free fund take into account the trend of increasing regulation of tobacco products, and the possibility of future settlements or judgments which may impose financial burdens on the tobacco industry?

Second, to what extent can a fiduciary take into account aspects of investing, other than strict risk and return considerations? This second question arises in two contexts. In some instances, a fiduciary believes that stocks in a particular industry represent an investment which is equal to that available from other available investments, but wishes to avoid investing in stocks in that industry based on nonfinancial concerns. For example, a fiduciary might believe that socially screened investments were equal in potential risks and returns to other investments, but choose the socially screened investments over other investments because of its opposition to practices in the screened industry. In other instances, a fiduciary believes that excluding stocks in a particular industry from its portfolio might increase risks relative to returns (by causing less diversification of the portfolio), decrease returns relative to risks (by excluding stocks which have historically been profitable), or increase transaction costs (by requiring the divestiture of existing stocks and the purchase of other investments), but nevertheless wishes to exclude such stocks based on social concerns.

Summary of Legal Issues

Different types of institutional investors are subject to different legal standards. For example, a pension fund of a private corporation would be subject to federal standards under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"). A state or local retirement system would typically be subject to regulation under federal and state Constitutional principles, as well as under extensive state statutory provisions. An institutional investor other than a pension fund might be subject to regulation under a state (profit or nonprofit) corporations act, the Uniform Management of Institutional Funds Act ("UMIFA"), other state statutes, or common law fiduciary standards.

A second point to remember is that the case law has not been particularly instructive when it comes to socially responsible investing. Thus, in many cases, the only authority consists of cases and other authorities which deal with fiduciary standards generally. And court cases have typically dealt with situations involving reckless or grossly imprudent investment choices, rather than situations in which a fund might lose a few basis points of investment return due to consideration of social factors. Thus, the language of case law is often quite broad and sweeping. However, in actual practice, trustees have not to date been held liable for damages incurred due to consideration of social factors in instances in which the difference in return between a socially screened fund and other available funds is small.

Nevertheless, some general principles apply to socially screened investments, as follows:

1. Socially screened investments, like any other investments, are subject to fiduciary standards. All judgments about the prudence of fiduciary actions are to be made from the perspective of the time the decisions were made, not in hindsight. The relevant courts and agencies have long recognized that estimating risks and returns is imperfect. Provided that the fiduciaries exercise both the substantive and the procedural component of their fiduciary duties (see paragraph 2, below), a court is likely to give great deference to their investment decisions, even if those decisions later prove to have been less than optimal.
2. Fiduciary duties have both a substantive and a procedural component. On the substantive side, a fiduciary needs to maintain a written investment policy statement on investments, and have investment decisions made by a "prudent expert." There should be a due diligence procedure for selecting the "prudent expert." The due diligence process for searching for an appropriate money manager to execute a socially responsible investment initiative should be the same as the process for selecting any other money manager. A fiduciary who imposes social screens on investments without making adequate investigation into the resulting risk and return characteristics thereby violates his or her procedural fiduciary duties.

   A fiduciary who makes an adequate investigation, but then makes an investment decision that exposes beneficiaries to a risk that is excessively high relative to return, thereby violates his or her substantive fiduciary duties. For example, if a fiduciary follows all of the due diligence standards set forth in the preceding paragraph, but then selects an investment manager based on the manager's relationship to the fiduciary or on kickbacks the investment manager will provide to the fiduciary, would be in violation of the substantive fiduciary duties.

3. In determining the risk and return ratio of social screening of investments versus making other investments, fiduciaries should consider risk factors specific to the particular screened industry.
4. Fiduciaries of pension plans must consider the consequences of their investments to future retirees as well as current retirees. For example, they should take into account societal shifts which may affect investments over the long term, even if not in the short term.
5. Fiduciaries must consider transaction and market impact costs as well as the theoretical value of investments. Thus, for example, situations may arise in which it would be prudent not to invest further in particular stocks, but in which it would not be prudent to divest all such stocks immediately.
6. The depth of the screen will in many instances have an impact on the above factors. For example, any "tobacco-free" fund would presumably not invest in Philip Morris, the business of which is primarily tobacco-related. However, other companies such as Eastman Chemical or H.B. Fuller make such items as cigarette paper and filters, but are not involved in the production or sale of tobacco as such. Thus, some tobacco-free funds might invest in them, while others would consider them off-limits. Typically, the more thorough the screen, the more likely it is to lower returns and/or diversification of the fund as a whole. Similarly, imposing multiple screens (e.g., for tobacco products, alcoholic beverages, pornography, gambling, the defense industry, and certain food producers) is likely to have a more negative impact on returns and/or risk than imposing only a single screen.
7. If an investment option which involves social screening is at least as prudent, taking into account the balance between risk and likely investment return, as other investments a pension plan or other institutional investor could make, avoiding certain investments based on nonfinancial factors is not a fiduciary violation.
8. Suppose that even after considering risks specific to the screened-out industry or industries, a social screening policy appears likely to produce lower returns in relationship to its risks, or higher risks in relationship to its returns, than other investments available to a fiduciary. If the difference is de minimis, at least one state court has held that the investment does not violate common law fiduciary standards applicable to non-ERISA pension plans or Constitutional standards applicable to governmental plans. Unfortunately, even that case does not indicate how large a variance would be considered de minimis. The Department of Labor has taken the opposite position under ERISA. And even under state law, the issue is much less clear than if the risks and returns were at least as great for the socially screened fund as for other investments.
9. Despite the comments in paragraph 9, above, to the extent state or federal Constitutional issues do not arise, an institutional investor, other than a pension fund subject to ERISA, can typically avoid fiduciary issues if an applicable statute specifically permits the fund to avoid the screened-out investments, or if the trust or other documents contain language permitting the fund to avoid the screened-out investments, and such language is not prohibited by applicable law. This contrasts with an ERISA plan, in which plan language cannot eliminate fiduciary issues. However, statutory or trust language calling for social investments regardless of fiduciary consequences is rare; more typically, a preference for avoiding certain types of investments is made subsidiary to general fiduciary standards.
10. Even if a pension fund's fiduciaries cannot be certain to be free from liability in making a decision to invest in a socially screened fund, they can often by following certain standards permit plan participants to choose among a variety of funds, which include a number of funds which would be prudent without regard to social considerations, as well as socially screened funds, without incurring fiduciary liability.

Analysis

The concept that it is impermissible to use institutional assets to foster purposes other than the financial good of the parties toward whom fiduciary duties run is an old one, predating even the Employee Retirement Income Security Act of 1974 ("ERISA"). See, e.g., Blankenship v. Boyle, 329 F.Supp. 1089 (D.D.C. 1971), in which the fiduciaries of the United Mine Workers of American Welfare & Retirement Fund of 1950 were held liable for damages caused by keeping large sums of cash with the National Bank of Washington on a no-interest basis. The court held that trustees appointed by the United Mineworkers of America had done this in order to foster the interest of the union (which owned and controlled the National Bank of Washington), to the detriment of the plan participants.

In the aftermath of the passage of ERISA, the law that applies to institutional investors depends in large part on (a) whether the investor is a employee benefit plan or some other type of institutional investor, and (b) if the investor is an employee benefit plan, the type of employer. Thus, this report deals separately with employee benefit plans of businesses organized to make a profit (for convenience, referred to as "taxable employers"), church plans, governmental plans, plans of other nonprofit organizations, and other institutional investors.

1. Employee Benefit Plans of Taxable Employers (Including Collectively Bargained Plans)

The major types of plans of taxable employers that might consider investment in socially screened funds are qualified plans,⁽¹⁾ and nonqualified deferred compensation arrangements for management and highly compensated employees ("top hat plans"). The Employee Retirement Income Security Act of 1974, as amended ("ERISA"), governs any pension plan maintained by an employer or union that affects interstate commerce, other than (1) a governmental plan, (b) a church plan, (c) a plan maintained outside of the United States primarily for the benefit of nonresident aliens, or (d) an unfunded excess benefit plan. ERISA section 4. Thus, it is the major source of federal law dealing with plans of taxable employers.

ERISA was enacted in response to a variety of weaknesses in the pension system. Some employers required unrealistically lengthy periods of participation, and penalized employees for even brief breaks in employment. Even those employees who qualified for pensions sometimes found that pension assets were insufficient to cover benefits. These problems were exacerbated by imprudent or even dishonest investment practices. These problems were highlighted by the collapse of the Studebaker Corp. in 1964. When the company declared bankruptcy, even fully vested, long service employees lost substantial pension benefits. Congress then began hearings which culminated ten years later in the passage of ERISA, which contained a variety of initiatives to prevent similar occurrences in the future. These initiatives included funding standards, reporting and disclosure requirements, plan termination insurance, and minimum coverage requirements. They also included a variety of fiduciary rules. These fiduciary rules are typically of the greatest concern to pension funds which are considering investment in socially screened funds.

a. Qualified Plans

For qualified plans of ERISA-covered employers, the Internal Revenue Code of 1986 ("Code") and ERISA represent the major statutory constraints on investments. Section 404 of ERISA (dealing with fiduciary standards) and sections 406 through 408 (dealing with prohibited transactions, self-dealing, and limitations of the percentage of assets which can be invested in certain kinds of investments) are the primary sections of ERISA relevant to socially screened investing. Similar restrictions are found in the exclusive benefit rule of Code section 401(a)(2) and the prohibited transaction rules of Code section 4975.

To the extent that individual participants are permitted to select the investments of their accounts under qualified plans, and that the investments from which the selections can be made include a variety of funds which would be prudent regardless of social considerations, ERISA section 404(c) would provide certain additional protections to fiduciaries if the plan's investment selection procedures meet its standards. In addition, for those qualified plans that cover collectively bargained employees (both single employer plans and multiemployer plans), the provisions of the Taft-Hartley Act and collective bargaining agreements could impose additional constraints. We discuss each of these issues below.

Because specific precedents concerning socially screened investment funds are sparse, the following sections of this letter deal with not only socially screened investments in particular, but social investment, divestment, screening, and economically targeted investments in general. In addition, we have spoken informally with staff of the relevant legislative committees, and officials at each of the relevant federal agencies (the Internal Revenue Service and the Department of Labor), to ascertain the current views of the Hill and the agencies on the issues presented.

(1) ERISA and Code Fiduciary Standards
(a) In General

ERISA contains several provisions governing plan investments. ERISA sections 403(c)(1) and 404(a) impose the general fiduciary prudence and diversification standards. Thus, the question presented is whether investing in socially screened funds would be considered a violation of the fiduciary standards of ERISA sections 403 and 404.⁽²⁾

In analyzing the issue of socially screened investments, a fiduciary needs to consider (a) whether socially screened investments are "prudent" within the meaning of section 404, and (b) whether consideration of nonfinancial factors violates the rule in sections 403 and section 404 that plan assets "shall be held for the exclusive purposes of providing benefits to participants in the plan and their beneficiaries and defraying reasonable expenses of administering the plan."⁽³⁾

Under ERISA, all judgments about the prudence of fiduciary actions are to be made from the perspective of the time the decisions were made, not in hindsight. The relevant courts and agencies have long recognized that estimating risks and returns is imperfect. Provided that the fiduciaries exercise both the substantive and the procedural component of their fiduciary duties (see below), a court is likely to give great deference to their investment decisions, even if those decisions later prove to have been less than optimal.

Fiduciary duties have both a substantive and a procedural component. A fiduciary who invests in a socially screened investment without making adequate investigation into its risk and return characteristics thereby violates his or her procedural fiduciary duties. A fiduciary who makes an adequate investigation, but then makes an investment decision that exposes beneficiaries to a risk that is excessively high relative to return, thereby violates his or her substantive fiduciary duties.

ERISA Reg.§ 2550.404a-1 sets forth the applicable regulatory interpretation of the statutory standards. Under the standards set forth in that regulation, a fiduciary could clearly decide to invest in a socially screened fund if the fiduciary had complied with both its procedural and substantive fiduciary duties, and believed that the return of that fund, relative to the risk, was greater than that otherwise available. For example, if a fiduciary under such circumstances believed that tobacco-related litigation lowered the expected returns while increasing the risk of tobacco investments to the point that tobacco stocks were not as good an investment as other investments available to the fund, the fiduciary could decide to exclude tobacco stocks from the portfolio.⁽⁴⁾

The question then becomes whether the "exclusive purpose" standard of ERISA section 404 means that a fiduciary cannot take into account any purposes other than financial returns, even in deciding between two equally investments with equal return/risk characteristics. The primary guidance on these points is ERISA Reg. § 2509.94-1. In essence, it permits the consideration of nonfinancial factors in selecting investments to the extent, and only to the extent, that the investments chosen involve a risk/return ratio at least as favorable as other available investments.

By its terms, ERISA Reg. § 2509.94-1 deals only with (and guidance is therefore limited to) ETIs. However, the Department of Labor has applied similar reasoning to social investments, such as investment in socially screened funds.

For example, ERISA Advisory Opinion Letter No. 98-04A (May 28, 1998), issued to the Calvert Group Ltd., dealt with investment in socially-responsible funds. The Department of Labor cited ERISA Reg. § 2509.94-1 in holding that:

The Department has expressed the view that the fiduciary standards of sections 403 and 404 do not preclude consideration of collateral benefits, such as those offered by a "socially-responsible" fund, in a fiduciary's evaluation of a particular investment opportunity. However, the existence of such collateral benefits may be decisive only if the fiduciary determines that the investment offering the collateral benefits is expected to provide an investment return commensurate to alternative investments having similar risks.

The Department of Labor has issued a series of opinion letters and information letters dealing with investment in real estate mortgages based on various social purposes which came to similar conclusions. See, e.g., ERISA Opinion Letter Nos. 88-16A and 85-36A, and information letters issued to Prudential Life Insurance Company of America (January 16, 1981); Electrical Industry of Long Island (March 15, 1982); Union Labor Life Insurance Company (July 8, 1988); and General Motors Corporation (May 14, 1993).

If the fiduciary reasonably believed, after taking the proper steps to assure compliance with both the procedural and substantive components of his or her fiduciary duties, that the return of a socially screened fund, relative to the risk, was at least equal to that otherwise available, taking into account social considerations in choosing between socially screened funds and other funds would clearly be appropriate under current law. However, ERISA Reg. § 2509.94-1 does not provide support for the proposition that a fiduciary can consider social consequences if the likely returns (after considering transaction and market impact costs), relative to risk, of a socially screened fund are even slightly less than those of otherwise available investments. Indeed, ERISA Advisory Opinion 98-04A, supra, specifically provides that, "A decision to make an investment, or to designate an alternative investment alternative, may not be influenced by non-economic factors unless the investment ultimately chosen for the plan, when judged solely on the basis of its economic value, would be equal to or superior to alternative available investments."

Thus, ERISA as currently interpreted by the Department of Labor would permit fiduciaries to consider the social consequences of alternative investments, to the extent that fiduciaries, after taking the proper steps to assure compliance with both the procedural and substantive components of their fiduciary duties, decided that the socially screened investment was equal to or better than available alternative investments on an economic basis. However, it would not permit fiduciaries to choose a socially screened investment which was not at least equal to available other investments.

The issue is complicated by hostility in Congress to ETIs and social investing. For example, H.R. 1594, passed by the House of Representatives on September 12, 1995, provided as follows:

It is the sense of the Congress that it is inappropriate for the Department of Labor, as the principal enforcer of fiduciary standards in connection with employee pension benefit plans and employee welfare benefit plans (as defined in paragraphs (1) and (2) of section 3 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002(1), (2))), to take any action to promote or otherwise encourage economically targeted investments.

The fact that this bill passed the House suggests that there is at least considerable sentiment on the Hill against ETIs (and by extension, other social investing).

H.R. 1594, supra, did not pass the Senate, and has not been reintroduced in the current Congress. However, social investing has again become a hot topic on the Hill this year due to the discussion in the current Congress of modifying Social Security. In a March 3 hearing of the House Ways & Means Committee Subcommittee on Social Security, the experience of public plans with social investing and ETIs was often cited negatively, as an argument against permitting the Social Security trust fund from investing in the stock market.

For example, the Honorable Maureen M. Baronian discussed her experience as a former trustee of the Investment Advisory Council for the State of Connecticut. She cited the Connecticut plans' experience in investing in the Firearms Division of Colt Industries, in order to shore up a local employer, and then having the firm file for bankruptcy. Peter J. Sepp, Vice President for Communications of the National Taxpayers Union, cited the Kansas Public Employee Retirement Systems' investment losses under its ETI program, and the Pennsylvania systems' investment in a Volkswagen plant.

Other witnesses argued that even in the absence of lowered investment returns, at least governmental entities should not be "meddling" in the affairs of private corporations. (By analogy, this argument could apply to state and local governmental retirement systems.) For example, Fred T. Goldberg, Jr., a former Commissioner of Internal Revenue, stated that, "All human experience shows that government is certain to misuse its ownership of private capital." Michael Tanner of the Cato Institute cited efforts by CalPERS and New York systems in influencing the election of the board of directors of General Motors as evidence of meddling.

Perhaps even more troubling, the proponents of having Social Security assets invested in the stock market often did not respond to the negative comments made about the experience of state retirement systems with social investing and ETIs. For example, Deputy Treasury Secretary Lawrence H. Summers defended the Administration's proposal to have some Social Security funds invested in the stock market not by defending the record of state systems, but by arguing that the Social Security proposal involves safeguards against the kind of activity engaged in by the states.

Robert Reischauer of the Brookings Institution said that experience suggests that, "concerns about political influence are exaggerated and that institutional safeguards can be constructed that would reduce the risk of interference to a de minimis level." The Century Foundation submitted written testimony which noted that, "CalPERS's energy is usually focused on maximizing shareholder value rather than imposing politically based demands on companies." The implication of both of these statements was that imposing politically based demands would be unacceptable, and that safeguards needed to be constructed to reduce the risk of such conduct.

Ironically, the one specific analysis of the effect of social investing on plans' investment returns suggested that it was small or even nonexistent. Deputy Treasury Secretary Lawrence H. Summers noted that over the period 1990-1995, public plans actually received returns that slightly exceeded those of private plans (although the differences were not statistically significant). Over the period 1968-1993, the performance of public plans was slightly inferior to that of private pension funds, but again the difference was not significant.

Nevertheless, social investment is clearly controversial in Congress. Under those circumstances, it is unlikely either that the Department of Labor will liberalize its position, or that ERISA will be changed legislatively in a way to make investing in socially screened funds easier.

Thus, if the likely returns (after considering transaction and market impact costs), relative to risk, of a socially screened fund are less than those of otherwise available investments, fiduciaries interested in investing in a socially screened fund may wish to consider ways of insulating themselves from liability. The most practical approach is typically through ERISA section 404(c), which insulates the fiduciaries from liability for certain participant-directed investments, if they follow its standards. We discuss ERISA section 404(c) in the following section of this letter.

(2) Participant-Directed Investments

ERISA section 404(c)(1) provides an exception to the normal fiduciary rules of ERISA for certain participant-directed investments. The Department of Labor has issued regulations interpreting this section, ERISA Reg. § 2550.404c-1. In general summary, these regulations provide that the protections of ERISA section 404(c) will apply if:

(a) the plan provides for a participant or beneficiary to exercise control over assets in his individual account,

(b) the participant or beneficiary has a reasonable opportunity to give investment instructions,

(c) the participant or beneficiary is provided or has the opportunity to obtain sufficient information to make informed decisions with regard to investment alternatives available under the plan,

(d) the plan provides a broad range of investment alternatives, and

(e) the participant or beneficiary actually exercises control over the assets in his account.

Further restrictions apply in the case of transactions with a related party, including the purchase of employer securities.

The regulations would not provide full protection to a fiduciary which allowed investment only in socially screened funds which had lower returns (after considering transaction and market impact costs), relative to risks, of other available investments. The preamble to the regulations under ERISA section 404(c) emphasized that the act of designating investment alternatives in an ERISA section 404(c) plan is a fiduciary function to which the limitation on liability provided by section 404(c) is not applicable.⁽⁵⁾ ERISA Advisory Opinion 98-04A made clear that in designating investment alternatives, non-economic factors could be considered only if the investment alternatives chosen, when judged solely on the basis of economic value, would be equal to or superior to alternative available investments.

Nevertheless, section 404(c) provides protection for fiduciaries who follow it to the extent that participants' own choices, rather than the fiduciaries' conduct, result in the losses. Thus, for example, a fiduciary which offered only socially screened investments, each of which offered economic benefits lower than those of comparable non-socially screened investments, would not be protected by section 404(c). However, provided the provisions of the regulations were followed, they would protect a fiduciary which offered the same portfolio of investments, plus a broad range of other investments (socially screened or otherwise) which offered economic benefits equal or superior to alternative available investments. Such a fiduciary would not be liable for an economic detriment which occurred as a result of a particular participant's choice of the socially screened funds.

A fiduciary who intends to rely on these regulations should consult the regulations themselves for the specifics. However, the regulations can clearly provide a measure of protection to fiduciaries who follow them.

(3) Special Provisions for Collectively Bargained Plans

In general, the Taft-Hartley Act and related labor laws do not impose restrictions on the investments of a plan that covers employees whose employment is subject to the terms of a collective bargaining agreement ("collectively bargained employees"). Indeed, National Labor Relations Board v. Amax Coal Co., 453 U.S. 322 (1981), confirms that a trustee of a collectively bargained plan, even if appointed by management, does not serve as a "representative" of the employer "for purposes of collective bargaining or the adjustment of grievances" in the performance of his or her fiduciary duties. However, if a plan covers collectively bargained employees, the plan's fiduciaries need to examine the collective bargaining agreement(s) involved to see whether they impose any special restrictions. In particular, they need to determine whether any collective bargaining agreement includes the trust's investment program as a subject of collective bargaining, in which case it may be considered a "term or condition of employment" which would be the subject of mandatory bargaining. In most but not all instances, collective bargaining agreements specifically exclude trust investments from mandatory bargaining, in which case a collectively bargained plan would be under no more restrictions than any other plan.

b. Top Hat Plans

The fiduciary requirements of ERISA do not apply to "a plan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees" (a "top hat" plan). ERISA section 401(a)(1). Nevertheless, ERISA section 514, excludes such plans from most state regulation.

Technically, top hat plans do not have investments, since the definition of a top hat plan requires that it be unfunded. In practice, however, such plans have used a variety of arrangements (most notably, so-called "rabbi trusts," under which trust assets are subject to the claims of the employer's creditors but are used to measure the employer's obligation to the participant) to hold assets intended to meet the employer's obligations under the plan. In such instances, neither ERISA nor state law would govern the investments of the rabbi trusts, except to the extent that an employee could argue that the investments violated a contractual right the employee had (e.g., a right under the top hat plan itself, or under an employment contract).⁽⁶⁾

2. Church Plans

Church plans primarily fall into three categories: qualified plans, plans described in Code section 403(b), and nonqualified deferred compensation plans.

a. Qualified Plans

Qualified plans maintained by churches or church-controlled organizations are not subject to the provisions of ERISA unless the relevant employer(s) elect to have them covered under ERISA (which few of them have done). ERISA section 4(b)(2); Code section 410(d). Nevertheless, courts may apply fiduciary standards to qualified church plans based on a variety of legal theories. First, they are subject to Code section 401(a)(2) (the exclusive benefit rule). Second, although the prohibited transaction rules of Code section 4975 do not apply to qualified church plans, Code section 503(b) imposes various self-dealing rules on such plans. Third, church plans are not subject to ERISA section 514, which generally preempts the application of state laws to pension plans. Thus, state statutory or common law (both that dealing with trusts as such, and that dealing with the requirements applicable to nonprofit corporations) can affect the fiduciary rules applicable to such plans. To the extent that state laws apply on their face, we discuss below the extent that Constitutional principles of separation of church and state might preclude their application.

(1) Code Section 401(a)(2) Exclusive Benefit Rule

Code section 401(a)(2) states that to be qualified, the trust instrument under a pension plan must make it:

impossible, at any time prior to the satisfaction of all liabilities with respect to employees and their beneficiaries under the trust, for any part of the corpus or income to be (within the taxable year or thereafter) used for, or diverted to, purposes other than for the exclusive benefit of [the employer's] employees or their beneficiaries. . . .

Revenue Ruling 69-494, 1969-2 C.B. 88, provided that the exclusive benefit rule applied to investments, as well as direct distributions, and would preclude an investment unless the investment met the following criteria:

(1) the cost must not exceed fair market value at time of purchase;

(2) a fair return commensurate with the prevailing rate must be provided;

(3) sufficient liquidity must be maintained to permit distributions in accordance with the terms of the plan; and

(4) the safeguards and diversity that a prudent investor would adhere to must be present.

Although Rev. Rul. 69-494 by its terms dealt only with investments in the employer, Rev. Proc. 72-6, 1972-1 CB 710 confirmed that it would apply to any investments of a pension trust.

H. Conf. Rept. 93-1280, at 302 (1974), 1974-3 C.B. 415, 463, stated as follows:

The Conferees intend that to the extent that a fiduciary meets the prudent man standard of the Labor provisions [of ERISA], he will be deemed to meet those aspects of the exclusive benefit requirements under ERISA.

This language makes it clear that compliance with the ERISA section 403 and 404 standards discussed above would ensure compliance with Code section 401(a)(2). It is not as clear that compliance with the ERISA standards, in the case of a plan not otherwise subject to ERISA, is required as a condition of qualification under Code section 401(a)(2). For example, in Shedco v. Commissioner, T.C. Memo 1998-295 (August 12, 1998), the Tax Court held that an isolated violation of the prudence requirements of ERISA section 404 would not disqualify a plan under Code section 401(a)(2). IRS officials, too, have informally indicated that the section 401(a)(2) rules may not be as stringent. For example, legal list statutes and economically targeted investment statutes are common in governmental plans (see discussion below), and the IRS has not historically challenged such statutes on Code section 401(a)(2) grounds.

Thus, a church plan can clearly take into account nonfinancial objectives to the extent that ERISA would permit an ERISA-covered plan to do so. It appears that a court would interpret Code section 401(a)(2) as imposing a looser standard than ERISA sections 403 and 404, but it is unclear just how much looser the standard might be.

(2) Code Section 503(b) Prohibited Transaction Rule

Code section 503(b) imposes prohibited transaction rules on governmental and church qualified plans. However, like the prohibited transaction rules of Code section 4975 for other qualified plans, the Code section 503(b) rules apply only if a pension plan is involved in a transaction with a related party, and thus would not typically be an issue with respect to socially screened investments.

(3) State Trust Law

State trust law takes two forms: common law restrictions on fiduciary investments and state statutes. In general, states have not attempted to regulate the investments of church retirement plans, as such. Thus, the primary fiduciary rules applicable to church plans come from the common law. The primary duties that are relevant to this discussion are the duty of loyalty set forth in Restatement of Trusts 3d § 170, the general standard of prudent investment set forth in Restatement of Trusts § 227, and the duty to follow the investment provisions of a statute or trust set forth in Restatement of Trusts 3d § 228.

Unfortunately, even the commentators disagree on the meaning of these sections. For example, the commentary in Restatement of Trusts 3d on section 227 states as follows:

Thus, for example, in managing the investments of a trust, the trustee's decisions ordinarily must not be motivated by a purpose of advancing or expressing the trustee's personal views concerning social or political issues or causes.

By contrast, Scott on Trusts states as follows:

Trustees in deciding whether to invest in, or to retain, the securities of a corporation may properly consider the social performance of the corporation. They may decline to invest in, or to retain, the securities of corporations whose activities or some of them are contrary to fundamental and generally accepted ethical principles. They may consider such matters as pollution, race discrimination, fair employment, and consumer responsibility.^34/

^34/ Similarly, in construing testamentary trusts, some have urged that social factors should override even the testator's express directives. For example, in the litigation concerning the desegregation of Girard College, a school established in Philadelphia in 1833 for "poor white male orphans," it was asserted that the testator's philanthropic designs would best be served by admitting male children of all races. Commonwealth of Pennsylvania v. Brown, 392 F.2d 120, 125 (3d Cir.), cert. denied, 391 U.S. 921, 88 S.Ct. 1811, 20 L.Ed.2d 657 (1968); Girard College Trusteeship, 391 Pa. 434, 480-481, 138 A.2d 844, 866 (Musmanno, J., dissenting), cert. denied, 357 U.S. 570, 78 S.Ct. 1383, 2 L.Ed.2d 1546 (1958). See also Clark, Charitable Trusts, The Fourteenth Amendment and The Will of Stephen Girard, 66 Yale L.J. 979, 990 (1957) (suggesting that the moral duty of trustees, who were agents of the city, to Philadelphia's two million citizens "was scarcely less than that to one dead testator"). Additionally, in Matter of London, 104 Misc. 372, 377-378, 171 N.Y.S. 981, 983-984 (1918), aff'd, 187 A.D. 952, 175 N.Y.S. 910 (1919), the Surrogate Court for New York County upheld an investment in war bonds at 3 2 % despite the testator's express command that the trustee should invest only in railroad bonds paying at least 4%. Noting that the nation was at war and needed the Aundivided aid, support and loyalty of every citizen," the court hypothesized that the testator would have sanctioned this investment had he been alive. Ibid.

Moreover, the case law regarding the application of these rules to "social investing" is sparse and mostly unhelpful. For example, an Oregon lower court decision concluded that an Oregon Board of Higher Education directive instructing divestment of the common stock of companies doing business in South Africa, Zimbabwe, and Namibia could not be enforced because it conflicted with the state's prudent investor statute. However, the trial court interpreted the law to require complete divestment, even in situations in which divestment was imprudent, and therefore did not consider whether a fund could take into account social policies in selecting among prudent investments. The appeals court did not reach the merits of this decision, but instead dismissed the case based on the plaintiffs' lack of standing. Associated Students of University of Oregon v. Oregon Investment Council, 82 Ore. App. 145, 728 P.2d 30 (1986), review denied, 303 Or. 74, 734 P.2d 354 (1987). Moreover, this case involved fiduciaries who had chosen not to comply with the directive, and plaintiffs who were seeking the support of the court to force the fiduciaries to apply it. Thus, it did not deal with a situation in which a participant or beneficiary sued fiduciaries who had taken into account nonfinancial objectives in investing trust assets.

In Withers v. Teacher's Retirement System, 447 F. Supp. 1248 (S.D.N.Y. 1978), aff'd. memo 595 F.2d 1210 (2d Cir. 1979), beneficiaries of the New York City Teacher's Retirement System argued that the trustees of the System had acted imprudently in deciding to purchase highly speculative New York City bonds as a way of averting the City's threatened bankruptcy. However, the court declined to treat averting the City's bankruptcy as a nonfinancial social purpose, reasoning that the solvency of the System depended on the City's ability to make continuing contributions to it, which would be jeopardized if the City became bankrupt.

Regents of the University of Michigan v. State, 166 Mich.App. 314, 419 N.W.2d 773 (1988), dealt with a state legislature's attempt to force a state university to cease further investments in stock of companies that did business in South Africa or the USSR, and, to the extent prudent, to divest itself of such stock. The court invalidated this attempt. However, the court based the decision not on general principles of prudence, but on specific state constitutional principles designed to assure the independence of the university from direct control by the legislature.

At least one case has, however, explicitly dealt with whether trustees who exercised overall prudence in the selection of investments could take into account social objectives, even if doing so reduced the benefits of plan participants. Board of Trustees v. City of Baltimore, 317 Md. 72, 562 A.2d 720 (1989), cert. denied sub nom. Lubman v. Mayor et al., 110 S. Ct. 1167, 107 L.Ed.2d 1069 (1990). In that case, various Baltimore City pension systems provided both fixed and variable benefits. The trustees of the systems argued that an ordinance which called for divestiture of stock in companies which did business in South Africa impaired the city's contractual obligations to the systems' participants, in violation of the Contract Clause of the U.S. Constitution. (Art. I, § 10.) They argued that to the extent the systems provided variable benefits, divestiture would reduce the participant's ultimate benefits, and that to the extent the systems provided fixed defined benefits, divestiture disturbed the participants' expectations that benefits would be well secured.

The court disagreed with the trustees. It found that the initial cost of divestiture of South African stocks was one thirty-second of 1% of the systems' assets and that the ongoing annual cost was one twentieth of 1%. It further found that:

[T]he initial and ongoing costs of divestiture may affect the systems' profitability, and, as a result, may slightly diminish the level of future variable benefits. Thus, in this respect, the Ordinances may indirectly change the City's obligation under its contracts with the beneficiaries. The cases, however, make it clear that an insubstantial change does not unconstitutionally impair the obligations of a contract.

The court went on to state that "given the vast power that pension trust funds exert in American society, it would be unwise to bar trustees from considering the social consequences of investment decisions in any case in which it would cost even a penny more to do so. Consequently, we hold that if, as in this case, the cost of investing in accordance with social considerations is de minimis, the duty of prudence is not violated."

Thus, while little authority exists at the state level on social investing, we believe that in the absence of a statute, at least the majority of courts would not hold social investment goals to be per se forbidden. However, courts may well vary as to whether they would simply require that fiduciaries not pursue them to the extent that they would have more than a de minimis negative effect on investment returns, or whether they would require that the socially screened investments be equal to or better than available nonscreened investments, after considering transaction and market impact costs.

Moreover, at common law a trustee is generally entitled to rely on the terms of a trust document specifying the types of investments in which the trust may invest or is forbidden from investing. Restatement of Trusts § 227, comments q and r. The only exceptions are if the trust terms are impossible or illegal, or if owing to circumstances unknown to the settlor of the trust and not anticipated by him, compliance would defeat or substantially impair the accomplishment of the purposes of the trust. Thus, to the extent that a trust under a church pension plan specifically provides for investment in socially screened funds, the trustee would normally be entitled to rely on such provision as a matter of the state common law of trusts.

Of course, the reverse is also true. If a church plan trust document states, for example, that investments are to be prudent within the meaning of ERISA, a fiduciary would need to comply with the ERISA standards even if they were otherwise inapplicable to the plan.

Theoretically, of course, states can modify the common law of trusts through statutory provisions. However, such modifications seldom involve modification of the common law rules discussed above as applied to trusts under church plans, although it is much more common to have statutory modifications of the common law rules in the case of governmental plans. (See below.)

(4) State Laws on Participant-Directed Investments

As discussed above, ERISA section 404(c)(1) provides an exception to the normal fiduciary rules of ERISA (in the case of plans which are subject to such rules) for certain participant-directed investments. We considered the question of whether a similar exception might be available under the common law for plans which are not subject to ERISA. For the reasons set forth below, we believe that there is, except to the extent that state statutory law may have modified the common law rules.

Under the common law, a beneficiary cannot hold a trustee liable for making investments based on factors other than the financial interests of a trust's beneficiary if the trustee complies with the following conditions:

• The beneficiary gave consent to the investments.

• The beneficiary was not under an incapacity.

• The beneficiary had knowledge of his legal rights and of all material facts which the trustee knew or should have known unless the trustee reasonably believed that the beneficiary knew them.

• The consent of the beneficiary was not induced by improper conduct of the trustee.

• The trustee has no adverse interest in the transaction.

Restatement of Trusts 3d § 216. These rules are quite similar to the rules set forth in the regulations under ERISA section 404(c), and we believe that they should be interpreted in a similar manner. Thus, for example, the fiduciaries would want to make sure that plan participants and beneficiaries were aware of any historical information which might suggest that socially screened investments would likely give rise to a lower rate of return than a non-screened alternative.

(5) First Amendment Issues

Church retirement plans facing a legal challenge to their decision to invest in socially screened investments have a defense they can offer that is not available to other types of retirement plans B namely, that their decision to select plan investments based on their respective religious beliefs is a decision protected by the First Amendment of the U.S. Constitution (or by a similar provision contained in a state constitution).

No court has directly addressed this issue (First Amendment protection for a church retirement plan's socially screened investment decisions. However, in one case, the Minnesota Court of Appeals (that state's highest level appellate court) determined that, under the First Amendment and a broader "Freedom of Conscience" Clause contained in the State of Minnesota's Constitution, Minnesota courts should not entangle themselves in reviewing issues of church doctrine and organization.⁽⁷⁾ Basich v. Board of Pensions, Evangelical Lutheran Church in America, 540 N.W. 2d 82 (1995). In this case, Rev. Basich and other plaintiffs complained of his denomination's determination that, in the absence of a participant's direction to the contrary, the participant's retirement plan accounts would be invested in a fund that had been divested of companies doing business in South Africa, under the denomination's South Africa divestment policy.⁽⁸⁾

Although the case was ultimately decided on a procedural issue on First Amendment grounds, it should be noted that the fiduciary responsibility issues discussed in this paper were addressed in Rev. Basich's complaint and were the subject of extensive discovery at the trial court level. It should also be noted that the Internal Revenue Service had previously ruled favorably on the status of the denomination's retirement plan as a section 403(b)(9) retirement income account program despite the presence of the socially screened default investment option. IRS Private Letter Ruling 9122081 (March 8, 1991)⁽⁹⁾

b. Section 403(b) Plans

The primary form of 403(b) plan in use by churches is a retirement income account program described in Code section 403(b)(9). Legislative history under Code section 403(b)(9) states as follows:

The conferees intend that the assets of a retirement income account for the benefit of an employee or his beneficiaries may be commingled in a common fund made up of such accounts. However, that part of the common fund which equitably belongs to any account must be separately accounted for (i.e., it must be possible at all times to determine the account's interest in the fund), and cannot be used for, or diverted to, any purposes other than the exclusive benefit of such employee and beneficiaries. Provided those requirements are met, the assets of a retirement income account also may be commingled with the assets of a tax-qualified plan without adversely affecting the status of the account or the qualification of the plan.

Because no case law has interpreted this legislative history, commentators generally assume that the exclusive benefit rule under Code section 403(b)(9) is identical to that which applies to qualified plans under Code section 401(a)(2), discussed above. And as discussed above, at least one private letter ruling has held that a socially screened default investment option will not impair the 403(b)(9) status of a fund.

For those churches which use 403(b)(7) custodial accounts, or variable annuities under Code section 403(b) in which the segregated asset account is invested in a mutual fund, the Code does not provide a specific exclusive benefit rule. Code section 403(b)(1)(C) provides that benefits under a 403(b) plan must be "nonforfeitable." However, it seems highly unlikely that a court would determine that social screening of investments would be considered a forfeiture for purposes of section 403(b).

Finally, the same state statutory and common law fiduciary and nonprofit corporation rules, and Constitutional limitations on the application of such rules, apply to 403(b) plans in the same manner as to qualified plans.

c. Nonqualified Plans

Traditional nonqualified deferred compensation plans of churches, like those of private employers, are typically unfunded, but the amount payable under them may be based on the performance of a "rabbi trust." However, unlike deferred compensation plans of private employers, church deferred compensation plans frequently cover rank and file employees, not just management or highly compensated employees. State statutory and common law fiduciary and nonprofit corporations rules, and Constitutional limitations on the application of such rules, are described above. However, we understand that, at least in the past, state agencies have often treated common law fiduciary rules as inapplicable, because a rabbi trust is by its terms subject to claims of the employer's creditors.

To the extent that a rabbi trust is exempt from common law fiduciary rules, because its investments are treated as investments of the employer, such investments may be subject to state law rules governing the investments of nonprofit employers. (See 5, below.)

3. Governmental Plans

Like church plans, governmental plans are exempt from the application of ERISA and the prohibited transaction rules of Code section 4975, but subject to state law and Code sections 401(a) and 503(b). Thus, many of the rules are the same as those discussed above. However, some important differences exist, as described below.

a. Qualified Plans

While both church and governmental plans are subject to state law, states have in practice been much more active in regulating governmental plans than church plans. State regulation of governmental plans has taken the form of: (a) Court interpretation of state constitutional provisions concerning impairment of contracts to require that imprudent investments not jeopardize governmental employees' benefits, and (b) state regulation of the investment of pension funds, such as "legal list" statutes. The recent approval by the Uniform Law Commissioners of the Uniform Management of Public Employee Retirement Systems Act ("UMPERSA"), which sets forth model standards for regulating the investments of governmental plans, has provided a road map which state legislatures and agencies are likely to follow in the future. Thus, besides the common law and Code section 401(a)(2) and 503(b) rules discussed above in connection with qualified church plans, governmental plans must comply with various state Constitutional and statutory restrictions on investments by governmental plans, as discussed below.

Moreover, although governmental entities are not typically subject to nonprofit corporation law, certain governmental instrumentalities may be. The plans of such entities would be subject to the same constraints as we discuss above with respect to church plans.

(1) Constitutional Restrictions

In many instances, courts have held that federal or state constitutional provisions dealing with impairment of contracts require that governmental pension funds invest prudently. Constitutional restrictions on investments are particularly significant, inasmuch as they are the one source of authority which cannot be overcome by contrary statutory or common law, or by the terms of the applicable trust document.

For example, Sgaglione v. Levitt, 37 N.Y.2d 507, 375 N.Y.S.2d 79, 337 N.E.2d 592, reargument denied, 37 N.Y.2d 924, 378 N.Y.S.2d 1027, 340 N.E.2d 754, interpreted Article 5, § 7 of the New York Constitution, which states as follows:

After July first, nineteen hundred forty, membership in any pension or retirement system of the state or of a civil division thereof shall be a contractual relationship, the benefits of which shall not be diminished or impaired.

The Sgaglione case dealt with a state statute which required the New York Common Retirement Fund, which served as the funding for the New York State & Local Retirement Systems, to invest in obligations of the Municipal Assistance Corporation for the City of New York. By its terms, the statute did not modify the benefit structure under the Systems. Moreover, the State of New York remained fully liable for the benefits promised under the Systems, even if no assets were available in the Common Retirement Fund to pay for them. The Attorney General therefore argued that the Constitutional provision was not violated, because it "is limited to the 'benefits' to which members and retired members of the retirement systems are entitled."

The court rejected the Attorney General's argument. It held that the Constitutional provision prevented a state statute from mandating that the Systems invest in MAC bonds, to the extent that the statute impaired means designed to assure benefits to public employees.

The Constitutional provisions, and the interpretation of those provisions, will obviously vary from state to state. Moreover, it is unclear how broadly the Sgaglione case should be interpreted. That case dealt with a situation in which the Systems were being required to purchase highly risky New York city bonds, at a time when New York city was staving off bankruptcy. The case of Board of Trustees v. City of Baltimore, supra, analyzed a similar provision under the Maryland Constitution. The court found that the Constitutional provision would not preclude a de minimis reduction in benefits and/or benefit security in order to foster the social purposes involved in divestment of stock in companies which did business in South Africa.

Thus, trustees of governmental plans should bear the Constitutional issues in mind in determining the permissibility of a particular governmental plan investing in socially screened funds. However, to the extent that the purchase of socially screened funds would have no more than a de minimis effect on returns (after taking into account transaction and market impact costs), the Board of Trustees v. City of Baltimore case, supra, provides an argument that such a purchase would not be prohibited by state or federal Constitutional provisions dealing with impairment of contracts.

(2) State Statutes and Regulations Concerning the Investment of Public Pension Funds

States generally exercise a high degree of regulation over governmental plans of state and local government. Besides the common law of trusts discussed above with respect to church plans, and state Constitutional provisions, states often impose additional fiduciary requirements by statute. As of 1995, twenty-three states imposed a "prudent investor" rule similar to ERISA either by statute or by court interpretation of common law. Only fourteen followed a more lenient "prudent person" rule, requiring that a fiduciary invest as prudently as a prudent person would for his own account rather than as prudently as a professional investor would.⁽¹⁰⁾ The remainder of the states used some variant or combination of these rules.

As of 1995, thirty-five states had conflicts of interest rules, which are often quite extensive. Most states also had codes of ethics, which frequently apply to public officials who manage pension funds.

Twenty-six states had some kind of "legal list" statute, which limited the types of investments in which governmental plans could invest. These ranged from ones totally forbidding equity interests by public pension funds to ones which merely prohibited certain kinds of investments deemed speculative. Although the modern trend is to eliminate legal list statutes in favor of a more generalized prudence standard, such statutes are obviously still a factor with which to contend.

State statutes also frequently provide for the enhancement of various social goals through pension fund investments. These range from prohibiting investments in certain foreign countries, to economically targeted investments, to encouragement of minority investment managers.

Most state statutes would not bar investment in socially screened investments as such, except to the extent that a socially screened fund might in a particular instance be "imprudent."⁽¹¹⁾ However, they might in some instances have an indirect effect on a governmental plan's ability to invest in a particular socially screened fund. For example, a legal list statute which prohibited investment in stocks would clearly prevent a governmental plan from investing in a socially screened stock-based fund.

(3) Uniform Management of Public Retirement Systems Act

As of 1997, the Commission on Uniform State Laws approved the Uniform Management of Public Retirement Systems Act ("UMPERSA"), governing the investment of governmental pension funds. Although only one state, South Carolina, has approved this act to date,⁽¹²⁾ it appears likely to influence future legislative changes at the state level. Section 6 of UMPERSA states as follows:

SECTION 6. GENERAL DUTIES OF TRUSTEE AND FIDUCIARY. Each trustee and other fiduciary shall discharge duties with respect to a retirement system: (1) solely in the interest of the participants and beneficiaries; (2) for the exclusive purpose of providing benefits to participants and beneficiaries and paying reasonable expenses of administering the system; (3) with the care, skill, prudence, and diligence under the circumstances then prevailing which a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an activity of like character and purpose; (4) impartially, taking into account any differing interests of participants and beneficiaries; and (5) in accordance with law governing the retirement program and system.

The reporter's notes on this section indicate that it is intended to track the fiduciary standards of ERISA, as discussed above with respect to ERISA-covered plans.

Some commentators have suggested that because UMPERSA calls for the repeal of all state laws which deal with social investing, that it impliedly prohibits such investing.⁽¹³⁾ However, Steven L. Willborn, the Reporter for the Uniform Law Commission on UMPERSA, explicitly rejected such an interpretation.⁽¹⁴⁾ Rather, he states that the Commission intended the repeal of state laws governing social investing only to result in the replacement of a patchwork of state standards with one uniform standard, with that standard being identical to the ERISA standard.

b. Section 403(b) Plans

The only governmental entities that are entitled to have 403(b) plans are public schools and universities. For those entities, the plans must fall within the standards set by Code section 403(b)(7) in the case of custodial accounts, or by Code section 403(b)(1) in the case of variable annuities under which the segregated asset account is invested in a mutual fund. Thus, to the extent discussed above in the case of church plans, the "nonforfeitability" rule of Code section 403(b)(1)(C) is the only provision in section 403(b) which could perhaps impose fiduciary standards on such plans, and we think such an event is highly unlikely.

c. Section 457 Plans

Code section 457 governs nonqualified deferred compensation plans of state and local governments. Code section 457(g) requires that assets and income of such plans must be held in trust for the exclusive benefit of participants and their beneficiaries. Thus, we discuss below the extent to which the exclusive benefit rule of section 457(g) might impose rules similar to those which would apply to a qualified plan under Code section 401(a)(2).

In addition, as discussed above with respect to qualified plans, trusts under governmental section 457 plans are subject to state Constitutional, statutory, and common law regulation.

4. Plans of Other Nonprofit Entities

Nonprofit entities other than governments and churches are subject to ERISA, and to Code sections 401(a)(2) and 4975. Conversely, they are also subject to ERISA's preemption provisions, which preclude the application of state fiduciary law to the investments of retirement trusts. Thus, in most respects, they are subject to the same rules as private, for-profit employers. (Code section 457 dues govern the operation of "top hat" nonqualified deferred compensation plans maintained by the nonprofit employers, but section 457(g) does not apply to nongovernmental employers, so the operation of these plans from the investment side is no different from that which applies to private employers.)

The two areas in which nonprofit entities differ from private corporations, however, is that (a) the entities are subject to state nonprofit corporation law, and (b) nonprofit entities described in Code section 501(c)(3) can maintain section 403(b) plans.

Thus, as described above with respect to church plans, restrictions applicable to nonprofit corporations or charitable trusts may affect plans of such entities. In addition, we set forth below some special considerations applicable to 403(b) plans of entities other than governmental or church organizations.

As described above, all 403(b) plans of governmental and church organizations are exempt from ERISA. However, in the case of 403(b) plans of other entities, ERISA will apply unless an exception is met.

The principal exception is set forth in ERISA Reg. § 2510.3-2(f). That section provides that a 403(b) annuity program which provides only for salary reduction contributions, and which meets certain other criteria set forth in the regulation, will not be treated as an employee benefit plan within the meaning of ERISA. Under those circumstances, the rules applicable to the 403(b) plan of a nonprofit organization would be identical to those discussed above for church and governmental plans.

By contrast, if a 403(b) plan (other than a church or governmental plan) provides for employer contributions which do not reduce the employee's salary, or otherwise fails to meet the standards set forth in the regulation, it will be subject to ERISA fiduciary standards just as if it were a qualified plan.

5. Other Institutional Investors

This section of the report is concerned with investments held directly by institutional investors other than pension funds, as well as unfunded rabbi trusts maintained by tax-exempt organizations. It does not deal with pension trusts, which are subject to the rules described above.

At common law, state nonprofit corporation laws often derive from the rules relating to charitable trusts on the theory that a charitable corporation is a trustee of property given it. Where trustees are limited to certain types of investments by statute or otherwise, it is a question of interpretation whether the statute is applicable to charitable corporations. Normally the "prudent investor rule" governs investments of funds by nonprofit corporations. This rule states that:

[A]ll that can be required of a trustee to invest, is, that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.

Harvard College v. Amory, 9 Pick. 446, 461 (1830).

Commentators who have considered this standard believe a fiduciary may consider the social implications of investments but that such considerations should not take precedence over financial considerations. Investments must not jeopardize the fund's safety or the adequacy of its return.

In states that have adopted the Model Nonprofit Corporation Act (the "Act") or some variation of it, there is a different standard that recognized the tendency by courts to acknowledge the similarities between the duties of nonprofit corporate directors and those of their "for profit" counterparts. Several jurisdictions have adopted the Act, which establishes a "business care" standard applicable to the investment of nonprofit corporate funds. The Uniform Management of Institutional Funds Act ("UMIFA") discussed below, also adopts this "business care" standard.

The "business care" standard has been expressed as follows:

[D]irectors of a [nonprofit] corporation are charged with the duty of managing its affairs honestly and in good faith, and they must exercise ordinary and reasonable care in the performance of their duties. They must act with fidelity to the interests of the corporation, and they are jointly and severally liable for losses of the corporation proximately resulting from bad faith, fraudulent breaches of trust, or gross or wilful negligence in the discharge of their duties.

Beard v. Achenbach Memorial Hospital Association, 170 F.2d 862 (10^th Cir. 1948).

The "business care" standard is less stringent than the "prudent investor" standard, noted above, and provides a greater margin of discretion in the management of investments. The "prudent investor" rule imposes a standard of simple negligence, in contrast to the gross negligence standard traditionally applied under the "business care" rule. Under the "business care" rule, directors of nonprofit corporations may consider social and financial factors equally when making investment decisions. See Solomon, Lewis D. and Coe, Karen C., "Social Investments by Nonprofit Corporation and Charitable Trusts: A Legal and Business Primer for Foundation Managers and Other Nonprofit Fiduciaries," 66 UMKC L. Rev. 213 (1997).

The enactment of UMIFA in most jurisdictions has had a wide impact in this area of the law. UMIFA served two purposes: 1) to clarify ambiguities in the law as they affected nonprofit organizations and their governing board and 2) to establish a more flexible standard over the management of investment funds by nonprofit organizations to prevent a fear of liability and excessive restriction on investments from discouraging effective management. Normally, UMIFA applies only to nonprofit corporations, but some jurisdictions have legislated its applicability to charitable trusts as well.

UMIFA provides that "members of a governing board shall exercise ordinary business care and prudence under the facts and circumstances prevailing at the time of the action or decision." The legislative intention of UMIFA was to impose the duty of care imposed on directors of business corporations rather than the "prudent investor" standard applicable to private trustees of eleemosynary institutions.

The Kansas Attorney General has issued an opinion that compared the "business care" standard and the "prudent investor" rule with respect to social investing. The opinion addressed the divestment of funds in South Africa and stated that the business care standard allows an investor to consider the security of a particular investment as it is affected not only by economic conditions, but also by social and political conditions. Kans. Op. Att'y Gen No 85-153 (1985) available in WL 204845.

In a similar vein, Michigan statutes provide an extremely flexible investment standard for nonprofit corporations, more flexible than that contained in UMIFA or allowed in the case of for-profit directors. Mich. Comp. Laws 451.1210 sets forth as follows:

This act shall not be construed to prevent an institution otherwise authorized by the terms of the applicable gift instrument establishing an endowment fund, or not prohibited by the terms of the applicable gift instrument establishing an institutional fund which is not an endowment fund, from making an investment or guaranteeing the obligations of others to further the educational, religious, charitable, or other eleemosynary purpose of the institution, regardless of whether any financial return is anticipated or any capital gain or loss is actually incurred.

It is clear that even an investment which could be expected to have markedly poorer investment returns than other available investments, or even no investment return at all, would be acceptable under this standard, if making the investment furthered the social purposes of the nonprofit organization.

It is imperative than any investor examine his or her particular state's statutes to understand the application of UMIFA. Some states apply UMIFA only to nonprofit corporations but may exclude certain types of endowments, such as state universities. As noted above, some states apply it to charitable trusts, some do not. The definitions contained in UMIFA are critical, and UMIFA does not apply to funds held by third party trustees. Although UMIFA has simplified this area of the law, it is still fairly complicated when one is considering the applicable law of various jurisdictions.

6. Liability Issues

a. Potential Liability of Fiduciaries

Theoretically, criminal statutes under federal law, and the laws of each of the states, require institutional investors to abide by their fiduciary duties. However, in practice prosecutors and the courts have applied these laws only to gross malfeasance, not to imprudent but not reckless investment choices. Thus, this section of the memorandum focuses primarily on civil penalties.

Moreover, the ERISA and common law financial penalties for imprudence apply only to the extent that trust beneficiaries had suffered harm as a result of imprudent investments. Thus, for example, if socially screened investments performed equally with or better than other investments available to the trust, the fiduciaries could not be held financially liable for investing in it, even if their actions at the time they invested might be seen as imprudent. They could, however, be subject to nonfinancial penalties, such as being removed as trustees, or even being prohibited from serving as trustees of other funds.

In addition, governmental plans present a special case. Often, sovereign immunity will preclude fiduciaries from having any potential liability, especially if their conduct is not considered reckless or grossly negligent.⁽¹⁵⁾ However, the rules for governmental plans are normally imposed by statute, and vary from state to state. Thus, the remainder of this discussion deals only with nongovernmental plans, or with governmental plans if the fiduciaries are not covered by sovereign immunity or statutory provisions precluding personal liability.

(1) For Imprudent Divestiture of Screened Out Investments

To the extent that a fiduciary was held to have improperly disposed of investments, at either ERISA or common law, the fiduciary could be charged with the loss of the value of the stock at the time of the decree, plus the value of the income that would have accrued to the trust if the trustee had retained the stock, plus the transaction and market impact costs inherent in the divestiture. However, the damages would be offset by the value of the investments and earnings of the replacement assets. ERISA section 409; Restatement of Trusts 3d § 208.

In addition, in the case of a plan which is subject to ERISA, ERISA section 502(l) imposes a 20% penalty, payable to the Department of Labor, on the damages as determined above.

(2) For Imprudent Socially Screened Investments

Under either ERISA or common law, a fiduciary who improperly invests trust assets can be held liable for the amount of trust funds expended in the purchase plus or minus the amount of a reasonably appropriate positive or negative total return thereon. ERISA section 409; Restatement of Trusts 3d § 210. Thus, for example, if a court held that a fiduciary had improperly screened investments, and those investments did poorly, the fiduciary could be held liable for the price originally paid for the socially screened investments, plus the amount the trust or other institutional investor could reasonably have been expected to earn on the amount of such purchase price, minus the actual value of the socially screened investments on the date of the decree.

In addition, a plan which is subject to ERISA would be subject to the 20% penalty of ERISA section 502(l), as described in the preceding section.

As a practical matter, however, it is much harder to obtain damages for failure to invest than for divestiture. The reason is that if a fiduciary improperly sells stock, showing the returns the stock would have engendered had the fiduciary retained them is normally relatively easy. Moreover, the divestiture itself may involve easily determinable transaction and market impact costs. By contrast, anyone who claims that a fiduciary's failure to acquire stock was imprudent must show what an appropriate return would have been if the fiduciary had invested more prudently. Prudent investment would not necessarily have involved the screened-out investments; it might have involved other investments which appeared to have, at the time of the investment, a risk/reward at least equal to the socially screened investments. Thus, it is necessary to show what the returns would have been on assets in which the trust never investedBnecessarily a more difficult task than showing actual returns on known assets.

b. Indemnification of Fiduciaries

ERISA section 410 provides the general rule on indemnification of ERISA fiduciaries. Under that section, use of plan assets to indemnify a fiduciary, or to purchase fiduciary insurance unless the insurance provided for recourse against the fiduciary, would be impermissible. However, it is permissible (and indeed common) for an employer maintaining a plan to provide fiduciary insurance for the fiduciaries of the plan.

Among governmental plans, often fiduciaries are not indemnified by the employer or under fiduciary insurance. Instead, many state statutes exempt plan fiduciaries from personal liability for negligent acts. The scope of such statutes varies, and indeed a recent court case held that such statutes would not provide protection in a situation in which a state retirement system had both management and union trustees, rather than trustees appointed only by the state. However, to the state that such exemptions apply, because they do not involve having the plan indemnify the fiduciary, they do not create a problem under Code section 401(a)(2).

Among church plans, the common law duty of loyalty set forth Restatement of Trusts 3d ' 170 imposes rules similar to the ERISA rules on indemnification provisions and the purchase of fiduciary liability insurance. Unlike the ERISA rules, the common law rules are of course subject to Restatement of Trusts 3d § 228, which provides that the general trust rules can be overcome by a contrary provision of the trust instrument or a statute. Nevertheless, given the constraints of Code sections 401(a)(2) and 403(b)(9), discussed above, the safest course for most church plans is to have the employer rather than the plan purchase fiduciary insurance, except in the case of insurance which permits recourse against the fiduciary.

Among fiduciaries of other institutional investors, the possibility of personal liability would typically depend on either the common law duty of loyalty, or state statutory provisions.

Footnotes

1. /^/ Technically, it is possible for a taxable employer to have a funded pension plan which is
subject to ERISA, but which does not meet the qualification rules of the Internal Revenue Code.
However, such plans are extremely rare, and generally arise due to an inadvertent failure of a
purportedly qualified plan to meet the qualification standards.

2. /^/ Code section 401(a)(2) has been held to impose fiduciary standards on plans. However,
the legislative history of ERISA section 404 indicates that compliance with the ERISA section
403 and 404 standards discussed above would clearly ensure compliance with Code section
401(a)(2). Thus, the Code section 401(a)(2) standards are now of interest only with respect to
plans, such as church and governmental plans, which are not subject to ERISA sections 403 and
404.

Also, Code section 4975 imposes prohibited transaction rules on ERISA-covered plans.
However, under Reorganization Plan Number 4 the Department of Labor has been delegated
the authority to interpret the relevant Code sections as well as the parallel ERISA sections.

Because of these factors, we focus our discussion on the ERISA rules.

3. /^/ ERISA sections 406 through 408 impose certain prohibited transaction rules on plans.
However, these sections would not be an issue unless dealings with a "party-in-interest" (e.g., the
employer which sponsored the plan, or a union which represented employees covered by the
plan) were involved.

4. /^/ See, e.g., Florida Attorney General Advisory Legal Opinion AGO 97-29 (May 27, 1997),
in which exactly this rationale was used in coming to the conclusion that the Florida state
systems could divest themselves of tobacco stock without incurring fiduciary liability.

5. /^/ 57 Fed. Reg. 46922 (October 13, 1992).

6. /^/ The lack of regulation of top hat plans is not accidental. Rather, it reflects a judgment
that "certain individuals, by virtue of their position or compensation level, have the ability to
affect or substantially influence, through negotiation or otherwise, the design and operation of
their deferred compensation plan, taking into consideration any risks attendant thereto, and
therefore, would not need the substantive rights and protections of [ERISA]." DOL ERISA
Advisory Opinion 90-14A.

7. /^/ The procedural issue before the Minnesota Court of Appeals was whether the trial court
had erred in refusing to grant the denomination's motion for summary judgment on the grounds
that the trial court lacked subject matter jurisdiction over the dispute. The Minnesota Court of
Appeals determined that this motion should have been granted, both on First Amendment and
Minnesota's Freedom of Conscience Clause grounds.

8. /^/ That policy, referred to as an "equivalency policy," generally provided that the Board of
Pensions would divest (and refrain from making new investments in) stock of companies with
South African holdings whenever the conditions of risk and return were equal between investing
in that stock or in stock of companies without South Africa holdings.

9. /^/ This favorable ruling can be seen as reflecting the IRS' view that the default investment
option did not violate the exclusive benefit rule applicable to section 403(b)(9) church retirement
income account plans.

10. /^/ These statistics are taken from Protecting Retirees' Money: Fiduciary Duties and Other
Laws Applicable to State Retirement Systems, Third Edition, by Cynthia Moore of the National
Council on Teacher Retirement.

11. /^/ But see, e.g., Kansas Statutes Annotated section 74-4921(3), which provides, in pertinent
part:

. . . No moneys in the [retirement] fund shall be invested or reinvested if the sole or
primary investment objective is for economic development or social purposes or objectives.

12. /^/ In 1998, UMPERSA was introduced in Nebraska, Washington, and Oklahoma, but no
action was taken on it in any of those states.

13. /^/ See, e.g., "An End to Social Investing," Plan Sponsor (July-August 1998), p. 62.

14. /^/ "UMPERSA Does Not Prohibit Social Investing," Plan Sponsor (October 1998), p. 8.

15. /^/ See, e.g., Florida Attorney General Advisory Legal Opinion 97-29 (May 27, 1997), which
held that, "The board [of trustees of a Florida state retirement system] is immune from liability
for any planning level decision it makes concerning divestiture of tobacco stock and members of
the board are not liable for any operational level decision unless they act wantonly and in bad
faith."

Presented at the Making a Profit While Making a Difference Conference, sponsored by Capital Missions Company, May 12, 2000

Copyright © by Calhoun Law Group, P.C. All rights reserved.

Published on: Friday, May 12, 2000 (7191 reads)