Tobacco Divestment and Fiduciary Responsibility: A Financial and Legal Analysis

Analysis of Legal Issues Concerning Tobacco Divestment and Socially Screened Investments

G. Daniel Miller and Carol V. Calhoun, Esqs.

In recent years, many fiduciaries of pension funds have considered whether they can consider social concerns along with financial ones in selecting investments for the funds. This trend has been particularly noticeable among plans of governmental entities, churches, and other nonprofit organizations, as well as among plans that cover employees whose terms and conditions of employment are the subject of collective bargaining (“collectively bargained plans”). Simultaneously, 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.

This report provides a background on social investment policies. Although the focus is on tobacco-free investment policies, the report recognizes that fiduciaries often implement such policies as part of a broader policy of socially screened investments. The report also analyzes the legal constraints that may apply to various types of pension funds and nonpension assets in carrying out a socially screened investment policy.

A trustee has a fiduciary responsibility to manage investments for the exclusive benefit of participants or beneficiaries. The question analyzed in this report 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 problem in analyzing this issue is that various people have used “social investing” to mean a variety of things. For example, at least some people have considered each of the following 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 as one way of decreasing a fund’s investment in tobacco stocks, although it is not, at least as yet, in common use.

History of Social Investing

Over the past 20 years, many 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, 17 states and the District of Columbia have passed laws requiring some sort of use of state pension investment strategy to oppose religious discrimination in Northern Ireland. Other states have restricted investment in Iran, Cuba, or companies that complied with the Arab League’s boycott of Israel.

Although the South African ban has ended, pension funds and non-pension funds continue not only to maintain but to increase their level of social screening. For example, the Social Investment Forum reported on November 4, 1999 that assets invested in socially responsible portfolios grew 82 percent between 1997 and 1999, roughly twice as fast as all assets under management.

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 that did business in South Africa) was prudent, because the unsettled political situation there made companies that did business there inherently more risky than those that did not. Most entities that avoid investments in tobacco stocks justify the policy on this basis. 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 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 tradeoff under which the potential investment returns for an individual might suffer at least to some extent to benefit the rest of society. While no one has questioned the right of individuals to make such tradeoffs in their private affairs, questions have arisen about whether a fiduciary charged with managing assets held for the beneficial ownership of others is entitled to make such a tradeoff on their behalf.

History of Tobacco Industry Litigation and Regulation

Since the 1950s, the tobacco industry has been subject to increasing challenges at the federal and state level, in both the courts and legislatures. In the 1950s, when the first tobacco litigation was instituted, the industry won all of the cases. However, as set forth below, the history since then has been of greater statutory restrictions, and greater success of plaintiffs in litigation.

On January 11, 1964, the report, “Smoking and Health: Report of the Advisory Committee to the Surgeon General of the Public Health Service” (the “Surgeon General’s report”) indicated a connection between smoking and various health problems. In response, Congress passed the Federal Cigarette Labeling and Advertising Act of 1965, for the first time requiring health warning on all cigarette packages. The first required warning read as follows: “Caution: Cigarette Smoking May Be Hazardous to Your Health.”

In 1967, the Federal Communications Commission (FCC) ruled that the Fairness Doctrine applies to cigarette advertising. Stations broadcasting cigarette commercials therefore had to donate air time to smoking prevention messages.

In 1970, Congress enacted the Public Health Cigarette Smoking Act of 1969. This Act banned cigarette advertising on television and radio effective in 1971. It also required a stronger health warning on cigarette packages: “Warning: The Surgeon General Has Determined that Cigarette Smoking is Dangerous to Your Health.” However, this Act also resulted in an end to the requirement that stations broadcast smoking prevention messages.

In 1972, under a consent order with the FTC, six major cigarette companies agreed to include a “clear and conspicuous” health warning in all cigarette advertisements. Because federal law already prohibited such advertisements on television and radio, this order affected primarily print and billboard ads.

In 1973, the Civil Aeronautics Board first required no-smoking sections on all commercial airline flights.

In 1975, Minnesota enacted the first comprehensive clean indoor air act, which restricts smoking in most buildings open to the public. This has been followed by tobacco-related legislation in many cities and states. Typical provisions include banning tobacco advertisements on any billboard, streetcar sign, streetcar, or bus; prohibiting the distribution of free cigarettes; smoking restrictions in private work places; banning tobacco advertising in sports stadiums; and earmarking part of the state cigarette excise tax to support smoking prevention programs.

In 1982, Congress temporarily doubled the federal excise tax on cigarettes to 16 cents per pack, to be in effect January 1, 1983, to October 1, 1985. This represented the first increase in the tax since 1951. Congress made the increase permanent in 1986. (The tax was increased to 20 cents in 1991, 24 cents in 1993, and will rise to 34 cents in 2000 and 39 cents in 2002. Moreover, President Clinton proposed a new 55-cent cigarette tax in his budget for 1999, although his efforts in this regard have so far been unsuccessful.)

In 1983, Rose Cipillone’s lawsuit alleging that her cancer (and subsequent death) had been the result of smoking became the first time that a court found in favor of a plaintiff in smoking-related litigation. The jury awarded her estate $400,000. However, the case was overturned on appeal, and sent back to the lower court for further consideration. Her heirs finally dropped the suit in 1992.

In 1984, Congress enacted the Comprehensive Smoking Education Act. This Act required the rotation of several different health warnings on cigarette packages and advertisements.

In 1987, Congress imposed a ban on smoking on domestic airline flights scheduled to last two hours or less. In 1989, Congress extended the ban to flights scheduled for six hours or less. Some airlines have voluntarily banned smoking on all flights.

In 1992, the Synar Amendment to the Alcohol, Drug Abuse, and Mental Health Administration (ADAMHA) Reorganization Act was the first Federal legislation enacted to require states to adopt and enforce restrictions on tobacco sales to minors. The Act set forth penalties to be imposed on state substance abuse funding if a state did not engage in proper enforcement activities.

In 1994, the Pro-Children Act prohibited smoking in facilities (in some cases portions of facilities) in which certain federally funded children’s services are provided on a routine or regular basis. This included schools, day care facilities, etc.

In 1994, Mississippi became the first state to sue the tobacco industry to recover Medicaid costs for tobacco-related illnesses. Early lawsuits had often run into difficulties based on tobacco-industry arguments that smokers had been as well informed as tobacco companies about the risks of smoking, and therefore had voluntarily assumed those risks. However, because this case involved a plaintiff that was not a smoker, it avoided some of the problems of other litigation, and was finally settled with a cash payment to the state.

A rash of lawsuits by other states followed the filing of the Mississippi lawsuit. In 1995, the state of Minnesota brought Minnesota v. Philip Morris, C1-94-8565, 2d Judicial District (May 8, 1998). The Minnesota suit not only resulted in a $6 billion settlement, but caused public disclosure of hundreds of thousands of tobacco industry documents dealing with the effects of tobacco that the industry had sought to keep confidential. During this litigation, Liggett Group, Inc. also turned over documents allegedly showing that the tobacco industry knew of health problems and misled customers.

In 1995, the Department of Justice reached a settlement with Philip Morris to remove tobacco advertisements from the line of sight of TV cameras in sports stadiums. The Department’s position was that the federal ban of tobacco ads on TV also covered placement of cigarette billboards in a position in which viewers would see them during game broadcasts.

In 1995, Brown & Williamson filed suit against Jeffrey Wigand, a former employee, for theft, fraud, and breach of contract. Mr. Wigand counterclaimed for invasion of privacy and holding him in a false light. Wigand v. Brown & Williamson (Kentucky). The company claimed that Mr. Wigand had breached employee confidentiality agreements by providing information regarding the tobacco company’s research and business operations to the Washington Post and to plaintiffs in a products liability suit. Mr. Wigand had provided information to CBS’s “60 Minutes” for a segment that the network chose not to air because of the risk of being sued. On November 29, 1995, Mr. Wigand gave a sworn deposition describing numerous tobacco industry practices. A court order sealed his testimony, but it was leaked to the Wall Street Journal and formed the basis of the Journal’s January 26, 1996 article, “Cigarette Defector Says CEO Lied to Congress About View of Nicotine,” by Alix M. Freedman. In the wake of the publication of the Wall Street Journal article, on February 4, 1996, CBS aired the previously canceled segment.

In 1996, the Liggett Group, the smallest of the nation’s five major tobacco companies, settled its liability in the Castano v. The American Tobacco Company, Inc. (Fifth Circuit) class action lawsuit, the biggest and most visible tobacco liability case. This represented the first time that a tobacco company had taken financial responsibility for tobacco-related diseases and death.

In 1996, the American Medical Association called for divestment of tobacco stocks by mutual funds. This resolution increased the interest of some organizations, pension plans, and individuals in divesting themselves of tobacco stocks, or in investing in tobacco-free mutual funds.

In 1996, in Grady Carter v. Brown & Williamson Tobacco Corp., a Florida jury awarded Carter $750 million based on his claim that he had contracted lung cancer from smoking Lucky Strike cigarettes. The case was overturned on appeal in 1998.

In 1997, the parties reached a settlement in Mangini vs. R.J. Reynolds Tobacco Company, San Francisco Civil Number 939359. The plaintiffs alleged that use of Joe Camel advertising constituted an unfair business practice by allegedly targeting youth. The settlement resulted in a $10 million payment by the company to fund youth anti-smoking advertisements in California and the release of certain documents referring to minors and the Joe Camel advertising campaign.

In 1997 and 1998, the states of Mississippi, Florida, Texas and Minnesota settled their Medicaid lawsuits with the tobacco industry in exchange for industry payments totaling $40 billion over 25 years, plus other industry concessions on marketing and lobbying activities.

In 1998, in Roland Maddox v. Brown & Williamson Tobacco Corp., a Florida jury awarded the estate of Roland Maddox $952,000 based on his claim that he had contracted lung cancer from smoking Lucky Strike cigarettes. For the first time, the jury award included punitive damages totaling $450,000. The case is on appeal.

In 1998, nonsmoking flight attendants settled Broin v. Philip Morris Companies, Inc., a lawsuit based on allegations of damages from second-hand smoke. Under the settlement, Phillip Morris set aside $300 million to research the effects of second-hand smoke. Damages to individuals could be obtained only in individual suits. However, the settlement allowed individual plaintiff suits — even those whose statute of limitations had expired — to continue against the tobacco industry.

On November 16, 1998, eight state Attorneys General announced that they had negotiated a national settlement that imposed sweeping bans on the marketing of tobacco products and provided $206 billion to the states to settle their suits. All 46 states and territories subject to the settlement have received approval in their respective courts. Under the settlement, the tobacco companies are required to make the first payment to the states when 80 percent of the states, representing 80 percent of the total allocation, have received court approval and their appeal periods have expired.

In February 1999, in Patricia Henley v. Philip Morris, a San Francisco jury awarded $50 million in punitive damages to a former heavy smoker who lit her first cigarette at a high school dance and went on to develop inoperable lung cancer at age 51. The case is on appeal.

In March 1999, in Jesse Williams v. Philip Morris, an Oregon jury ordered Philip Morris to pay the heirs of a former three-pack-a-day smoker $81.5 million. Most of the award represented punitive damages and is the largest ever amount awarded in a tobacco case brought on behalf of an individual plaintiff.

In August 1999, Engle, et al. v. R.J. Reynolds Tobacco, et al. (Dade County, Florida, Eleventh Judicial Circuit) entered the damages phase of this three-phase trial. This is the first class action brought on behalf of smokers to go to trial. The plaintiffs are Florida residents alleging injury from smoking cigarettes; a damage award could range as high as $200 billion or more. In October, a Florida appeals court ruled that damages could be awarded in a lump sum, rather than on the basis of individual assessments. The ruling sent tobacco stocks plummeting to their lowest levels in years.

In September 1999, President Clinton announced that the Justice Department is bringing a lawsuit to recover the federal government’s costs of treating sick smokers. The government estimates that is spends $25 billion annually in health claims paid to veterans, military personnel, federal employees and elderly on Medicare who have contracted smoking-related illnesses.

In addition to the lawsuit brought by the U.S. government, the governments of Bolivia, Brazil, Guatemala, Nicaragua, Panama and Venezuela have filed lawsuits in U.S. courts patterned on suits filed by U.S. states. The Marshall Islands and British Columbia have filed similar actions in their home courts. Several individual smokers also have filed lawsuits overseas in Argentina, Brazil, Canada, Italy, Japan, Scotland and Turkey. Class action suits have been filed in Australia, Brazil, Canada and Nigeria. It is expected that other foreign governments and individuals will also sue, as state governments did following the Mississippi litigation discussed above.

Various antismoking groups continue to push for further restrictions on tobacco. In the United States, some restrictions being suggested are the following:

• More restrictions on print ads, including elimination of the use of figures, such as the Marlboro Man, whom anti-smoking groups perceive as glamorizing cigarettes.
• Restrictions on the retail display of cigarette advertising.
• Penalties against the tobacco industry if youth smoking does not drop.
• Additional restrictions on tobacco-industry sponsorships of athletic events, which are limited but not entirely banned under the proposed settlement.
• Stronger health warnings on cigarette packs.
• Restrictions on the tobacco industry’s activities abroad.

The European Commission and the World Health Organization also are pressing for additional tobacco controls overseas. In 1998, the European Union endorsed a ban on all forms of tobacco advertising in 2001. In November 1999, the European Commission adopted a proposal for a directive on the manufacture, presentation and sale of tobacco products. The proposal’s principal features are as follows:

• Limiting the amount of tar and carbon monoxide to 10 milligrams per cigarette, and the amount of nicotine to 1 mg per cigarette.
• Revising health-warning labels on cigarettes, with “Smoking Kills” warnings printed in clear and bigger typeface.
• Requiring tobacco companies to provide national authorities with a list of ingredients and their quantities in the products they sell.

In October 1999, the World Health Organization began work on a Framework Convention on Tobacco Control. Under the convention, state parties would take appropriate measures to fulfill the following objectives:

• Protecting children and adolescents from exposure to and promotion of tobacco products and their promotion.
• Promoting smoke-free environments, and preventing and treating tobacco dependence.
• Improving knowledge and the exchange of information at the national and international levels.
• Setting specific obligations to address advertising, packaging, labeling and prices.

Questions Presented

As noted earlier, 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 that 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 that may impose financial burdens on the tobacco industry?

Second, to what extent can a fiduciary take into account social aspects of investing, other than the strictly financial aspects? This second question arises in two contexts. In some instances, a fiduciary believes that stocks in a particular industry represent an investment that 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 a tobacco-free fund was equal in potential risks and returns to other unscreened funds, but chooses the tobacco-free fund over other funds because of its opposition to smoking. 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 that have historically been profitable), or increase transaction costs (by requiring the divestiture of existing tobacco stocks and the purchase of other investments), but wishes to exclude such stocks based on social concerns. For example, it might avoid investing in tobacco stocks even if it felt that such stocks were likely to outperform the market generally.

This letter discusses these questions presented above. In doing so, we are aware that the Investor Responsibility Research Center (“IRRC”) is primarily interested in the propriety of excluding tobacco stocks from a fund’s investments. However, historically some fiduciaries that have wanted to exclude tobacco stocks have wanted to use their portfolios for other social purposes as well. Thus, this report discusses the legal issues surrounding social investment generally, as well as the specifics of tobacco-free investments.

Summary of Responses

In reviewing this report, the first point to note is that different types of funds are subject to differing legal standards. Plans that are subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), i.e., most plans other than governmental or church plans, are subject to a uniform federal standard. Governmental and church plans, and internal investments of tax-exempt organizations, are typically governed by state law. Different states phrase their standards in different ways, and the differences can be important.

A second point to remember is that the case law, either under ERISA or under state law, has not been particularly instructive when it comes to socially responsible investing. Thus, we have often had to examine cases and other authorities that deal with fiduciary standards generally. 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.

With these two points in mind, we can consider the following general principles applicable to socially screened investments:

1. Socially screened investments by pension funds and endowments, like any other investments they make, are subject to fiduciary standards. If the fiduciaries exercise both the substantive and the procedural component of their fiduciary duties (see paragraph 2, below), a court is likely to give 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. It is important to be able to show both that the fiduciaries took adequate steps to analyze risks and returns (the procedural component), and that their ultimate decisions were in accordance with the results of the prudence investigation (the substantive component).
3. In determining the risk and return ratio of a socially screened investment option versus one that is not socially screened, fiduciaries should consider risk factors specific to the particular screened industry. For example, in determining the risk and return ratio of a tobacco-free fund, fiduciaries should take into account the risks presented by tobacco litigation and regulation.
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 that may affect investments over the long term, even if not in the short term.
5. When considering divestment, 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 tobacco stocks, but in which it would not be prudent to divest all tobacco-related investments immediately.
6. The depth of the social investing 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 and H.B. Fuller make such items as cigarette filters and adhesives, 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 deeper the screen, the more likely it is to affect returns and/or diversification of the fund as a whole.
7. We have reviewed a companion report from BARRA Rogers Casey (see Chapter 3) concerning the financial impact of tobacco-free investments. Assuming a limited-depth tobacco screen, the report indicates that because tobacco companies represent a small percentage of companies available for investment, eliminating tobacco company stocks from an indexed portfolio typically has minimal effect on returns. Thus, the concerns are greatest in three situations: (a) for actively managed funds that are less diversified than indexed funds, (b) for funds that currently own tobacco stocks, and must incur transactional or market impact costs to dispose of them, or (c) for funds that screen for multiple social concerns in addition to tobacco. The more stocks that the screens exclude, the more effect the exclusions are likely to have on returns. However, even a de minimis reduction in expected investment returns relative to risks can pose problems, particularly for plans subject to ERISA.
8. If an investment option that is socially screened is at least as prudent, taking into account the balance between risk and likely investment return, as other investments a pension plan or nonprofit entity could make, avoiding certain investments based on nonfinancial factors is not a fiduciary violation. This is true regardless of whether the investor is a pension plan subject to ERISA, a pension plan not subject to ERISA, or another type of nonprofit entity.
9. Suppose that even after considering risks specific to the screened-out industry or industries, a socially screened fund 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 pension fund. If the difference is de minimis, as discussed below, 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.
10. Despite the comments in paragraph 9, above, a governmental pension fund that is not subject to state Constitutional provisions that affect investments can typically avoid fiduciary issues if an applicable statute specifically permits a fund to avoid the screened-out investments, regardless of what language appears in the trust. However, such language is rare; more typically, statutes make a preference for avoiding certain types of investments subsidiary to general fiduciary standards. If the trust instrument of such a fund provides for investment in such a manner, and no applicable state statute voids such trust provision, the trust instrument investment directives control. This contrasts with an ERISA plan, in which neither state statutory nor plan language can eliminate fiduciary issues.
11. Despite the comments in paragraph 9, above, a church pension fund can typically avoid fiduciary issues if the trust instrument provides for socially screened investments, and no applicable state statute voids such trust provision. Moreover, First Amendment issues could arise if a state statute attempted to void a church’s preference for socially screened investments. This contrasts with an ERISA plan, in which similar plan language cannot eliminate fiduciary issues.
12. 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 that would be prudent without regard to social considerations, as well as socially screened funds, without incurring fiduciary liability.
13. For nonprofit entities, the permissibility of investing in a socially screened fund — even if the fund appears likely to produce lower returns, in relationship to its risks, than other available investments — depends on specific state law. In some cases, nonprofit corporations are subject to a “prudent investor” standard similar to ERISA; in others, they are subject to a lesser “business care” standard that would allow the consideration of social objectives equally with financial ones.

Analysis

The idea that it is impermissible to use pension plan assets to foster purposes other than the financial good of plan participants and beneficiaries 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 court held the fiduciaries of the United Mine Workers of American Welfare & Retirement Fund of 1950 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 Mine Workers of America had done this 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 pension plans depends in large part on the type of employer. Thus, this report deals separately with plans of businesses organized to make a profit (for convenience, referred to as “taxable employers”), church plans, governmental plans, and plans of other nonprofit organizations.

1. 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, and nonqualified deferred compensation arrangements for management and highly compensated employees (“top hat plans”). 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, ERISA 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 that culminated 10 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 that are considering investment in socially screened funds.

a. Qualified Plans of Taxable Employers

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 plan assets that 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 a qualified plan permits participants to select the investments of their accounts, and that the investments from which they can make the selections include a variety of funds that 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. Conversely, 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 terms that constrain or permit socially screened investments. We discuss each of these issues below.

Because specific precedents concerning socially screened investment funds are sparse, the following sections of this report deal with not only socially screened investments in particular, but social investment, divestment, screening, and economically targeted investments (“ETIs”) 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 — In General

ERISA contains several provisions governing plan investments. ERISA sections 403(c)(1) and 404(a) (set forth in Appendix 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.

In analyzing the issue of investment in socially screened funds, we considered (a) whether investment in socially screened funds is “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.”

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 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.

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 investments with equal return/risk characteristics. The primary guidance on these points is ERISA Reg. § 2509.94-1, which is set forth in Appendix B. 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 that 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 an ERISA-covered 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, the fiduciary’s 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, 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 ERISA-covered fiduciaries to consider the social consequences of alternative investments, to the extent that such 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 that 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 due to the discussion in the current Congress of modifying Social Security. In a March 3, 1999 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 to invest 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, 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, 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 the California Public Employees’ Retirement System (CalPERS) and New York systems in influencing the election of the board of directors of General Motors as evidence of such meddling.

Perhaps even more telling about the prevailing view of ETIs and social investing, even 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 respect to ETIs and social investing. 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 testified at that same hearing 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 that 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 presented at the hearing on 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.

Similarly, a paper prepared by Alicia Munnell et al., at Boston College in 1999, entitled “Investment Practices of State and Local Pension Funds: Implications for Social Security Reform,” makes the following points:

• Economically targeted investments account for no more than 2.5 percent of total state and local holdings.

• Whereas early forays into ETIs resulted in some loss of returns, more recent examples show competitive returns.

• In only three states have public plans seriously engaged in shareholder activism.

• The only significant divestiture to date has been related to South Africa.

As the Munnell paper summarizes the situation, “In short, the story that emerges at the state and local level is that while in the early 1980s some public pension plans sacrificed returns for social considerations, plan managers have become much more sophisticated. Today, public plans appear to be performing as well as private plans.”

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.

In view of the above, if the likely returns, 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 report.

(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, 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 regarding 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 to transactions with a related party, including the purchase of employer securities.

The section 404(c) regulations would not provide full protection to a fiduciary that allowed investment only in socially screened funds that had lower returns, relative to risks, than other available investments. The preamble to these regulations 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. 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 based on 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 that 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 arguably would protect a fiduciary that 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 those of alternative available investments. Such a fiduciary would presumably not be liable for an economic detriment that occurred because of a particular participant’s choice of the socially screened funds.

A fiduciary who intends to rely on the section 404(c) regulations should consult the regulations themselves for the specifics. However, the regulations can 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 of Taxable Employers

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, which is attached as Appendix C, 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 otherwise set aside for 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).

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. Church 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) which, as is discussed below, can be viewed as imposing certain fiduciary standards on qualified plans. 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 applies 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 C.B. 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 as the ERISA fiduciary standards. For example, legal list statutes and economically targeted investment statutes are commonly applied to governmental plans (see discussion below), and the IRS has not historically challenged such statutes on Code section 401(a)(2) grounds.

Thus, Code section 401(a)(2) would not prohibit a church plan from taking into account nonfinancial objectives to the extent that ERISA would permit an ERISA-covered plan to do so. It appears that a court could 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 applicable to 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.

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 3.5 percent despite the testator’s express command that the trustee should invest only in railroad bonds paying at least 4 percent. Noting that the nation was at war and needed the “undivided 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 to avert 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 that called for divestiture of stock in companies that 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 percent of the systems’ assets and that the ongoing annual cost was one twentieth of 1 percent. 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 funds be equal to or better than available nonscreened funds, 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 arguably 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, in our experience, 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 that 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 that are not subject to ERISA. For the reasons set forth below, we believe that there is such an exception, 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:

1. The beneficiary gave consent to the investments.
2. The beneficiary was not under an incapacity.
3. The beneficiary had knowledge of his legal rights and of all material facts that the trustee knew or should have known unless the trustee reasonably believed that the beneficiary knew them.
4. The consent of the beneficiary was not induced by improper conduct of the trustee.
5. 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 that might suggest that a socially screened investment would likely produce 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 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).

This issue (First Amendment protection for a church retirement plan’s socially screened investment decisions) has not been directly addressed by a court. 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. 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.

Although the court ultimately decided the case on a procedural issue on First Amendment grounds, the fiduciary responsibility issues discussed in this report 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)

b. Church 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, practitioners 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 church retirement fund.

For those churches that 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) does provide 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 church 403(b) plans in the same manner as to church qualified plans.

c. Church 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 assets held in 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, to church plans (including church nonqualified plans) are described above. However, it is at least arguable that common law fiduciary rules are inapplicable, because assets of a rabbi trust are in general treated more like assets of the employer than like normal trust assets.

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. Governmental qualified plans are also subject to 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. Governmental 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 that 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. To the extent that a governmental entity held assets outside of a trust, those assets would arguably be subject to the same constraints as discussed below with respect to nonpension assets held as endowments.

(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 that 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 (1975), reargument denied, 37 N.Y.2d 924, 378 N.Y.S.2d 1027, 340 N.E.2d 754 (1975), 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 that required the New York Common Retirement Fund, which served as the funding source 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 there found that the Maryland Constitutional provision in question would not preclude a de minimis reduction in benefits and/or benefit security to foster the social purposes involved in divestment of stock in companies that did business in South Africa.

Thus, trustees of governmental plans should bear the Constitutional issues in mind in determining the permissibility of applying social screens to the investments of a particular government plan. However, to the extent that application of such screens 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, 23 states imposed a “prudent investor” rule similar to ERISA either by statute or by court interpretation of common law. Only 14 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. The remainder of the states used some variant or combination of these rules.

As of 1995, 35 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 the application of social screens to a plan’s investments as such, except to the extent that the application of such a screen, or combination of screens, might in a particular instance be “imprudent.” However, they might in some instances have an indirect effect on a governmental plan’s ability to invest in a socially screened fund. For example, a legal list statute that 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, 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 that deal with social investing, it impliedly prohibits such investing. However, Steven L. Willborn, the Reporter for the Uniform Law Commission on UMPERSA, explicitly rejected such an interpretation. 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. Governmental Section 403(b) Plans

The only governmental entities 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. Governmental 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 that 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

The retirement plans of nonprofit entities other than governments and churches are generally subject to ERISA, and if they maintain section 401(a) qualified plans, 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 does govern the operation of “top hat” nonqualified deferred compensation plans maintained by 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 top hat plans maintained by 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 noted 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), which is found in Appendix E. That section provides that a 403(b) annuity program that provides only for salary reduction contributions, 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 that 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. Nonpension Assets Held as Endowments for Foundations, Universities, and Churches

This section of the report is concerned with investments held directly by endowments, including unfunded rabbi trusts maintained by tax-exempt organizations. It does not deal with pension trusts maintained by nonprofit organizations, 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: