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Are institutional investors and financial intermediaries legally required to consider ESG factors when making investment decisions? Must any additional non-financial principles and objectives be considered?
Federal and state law do not affirmatively require the integration of ESG-related considerations into the management of investments, except to the extent that applicable fiduciary duties would require a fiduciary to consider such matters in the interest of an entity and its owners, shareholders or other beneficiaries. For example, the Advisers Act of 1940 (the Advisers Act), the Investment Company Act of 1940 and The Employee Retirement Income Security Act of 1974 (ERISA) impose additional, federal-level fiduciary duties on investment advisers and benefit plan fiduciaries. The Securities and Exchange Commission (SEC), which administers the Advisers Act, has explained that an investment adviser has a duty to ‘adopt the principal’s goals, objectives, or ends’ and to make full and fair disclosure of all facts related to the advisory relationship. These responsibilities are implicated when an investment adviser or its client wishes to integrate ESG considerations into an investment strategy. In the case of retirement plans regulated under ERISA, the US Supreme Court has held that best interests of beneficiaries must be understood to refer to ‘financial’ rather than ‘nonpecuniary’ benefits. (Fifth Third Bancorp v Dudenhoeffer, 573 U.S. 409 (2014)) The US Department of Labor (DOL), which administers ERISA, has accordingly taken a similar position, providing in guidance issued in 2018 that ‘fiduciaries must not too readily treat ESG factors as economically relevant to the particular investment choices at issue . . . rather, ERISA fiduciaries must always put first the economic interests of the plan . . .’ In October 2021, the DOL proposed rules that would amend the DOL’s investment duties regulation with respect to the consideration of ESG factors in the selection of investments for retirement plans that are subject to ERISA and would include, among other things, ESG factors such as climate-change and workforce diversity and inclusion as examples of the facts and circumstances that can be considered if material to the risk-return analysis.
In March 2022, the SEC Division of Examinations issued annual examination priorities that included ESG investing and cybersecurity, among other things, as key examination priorities. In May 2022, the SEC proposed rule amendments to require specific disclosure of investment advisers’ use of ESG factors as part of their investment decisions and strategies, and proposed rules governing fund names that suggest the use of ESG investment strategies, among other things.
Insofar as an institutional investor or financial intermediary is a business organisation formed pursuant to state law, fiduciaries of the organisation may owe fiduciary duties (usually duties of care and loyalty) to the entity and its equity holders and are not required to consider ESG factors when making investment decisions, except to the extent that applicable fiduciary duties would require a fiduciary to consider such matters.
For managers of trusts, ESG factors are not favoured by the Uniform Prudent Investor Act (UPIA) in the jurisdictions where it has been adopted. Specifically, the UPIA places certain constraints on impact investing, in that the official comments provide that ‘no form of . . . ‘social investing’ is consistent with the duty of loyalty if the investment activity entails sacrificing the interests of trust beneficiaries – for example, by accepting below-market returns – in favor of the interests of the persons supposedly benefitted by pursuing the particular social cause.’
Considerations of principles and objectives developed by non-governmental and supranational organisations, such as the United Nations Principles for Responsible Investment (UNPRI) and the United Nations Sustainable Development Goals (SDGs), are not required as a matter of law.
What voluntary standards and best practices are commonly followed in your jurisdiction with regard to integrating ESG factors and other non-financial principles into investment decisions?
Investors pursuing ESG integration and impact investing strategies have adopted and promoted a wide variety of investment practices and are establishing investment vehicles designed to pursue their strategies. Common themes regarding strategy pertain to establishing general goals, marketing approaches, fund documentation, screening principles, due diligence, management and oversight of the investment (in the private side especially), engagement (on the public side especially), reporting to investors, and best practices for exiting and divestment. Investors focused on public company investment have encouraged public companies to increase their ESG-related disclosures and to follow disclosure standards set forth by non-governmental standard setters — for instance, the Task Force on Climate-related Financial Disclosures (TCFD), the Value Reporting Foundation (formerly known as the Sustainability Accounting Standards Board), and the Global Reporting Initiative (GRI) – and proxy advisory firms, specifically Institutional Shareholder Services (ISS) and Glass Lewis. Also influential are ESG indices, raters and rankers; while the primary function of these firms is to rate and sort companies on the basis of existing conduct, they influence ESG-related investment strategies by identifying best practices.
These developments are taking place against a backdrop of increasing recognition of contributions of non-governmental and intergovernmental institutions that have advanced ideas about standards and best practices in ESG investing, particularly the UNPRI and related initiatives, such as the SDGs and the UN Impact Standards for Private Equity Funds.
What voluntary and statutory measurement, reporting and disclosure frameworks are followed in your jurisdiction with regard to ESG and other non-financial factors?
Federal securities laws and regulations govern disclosures by investment managers and public companies, and disclosure on social and environmental topics under these laws may be required to the extent they fall under principles-based and prescriptive disclosure requirements and are material to the organisation. State laws may require additional, specific disclosures concerning specific ESG-related concepts.
Beyond these frameworks, companies, including investment firms, are increasingly issuing additional disclosures, on a voluntary basis, under frameworks and standards published by nongovernmental and intergovernmental organisations. According to research by the Center for Audit Quality (CAQ) (as of June 2021), 95 per cent of S&P 500 companies had detailed ESG information publicly available. Of the remaining 5 per cent, most companies published some high-level policy information on their website. CAQ reported that 74 per cent of S&P 500 companies referenced CDP standards (formerly known as the Carbon Disclosure Project), 72 per cent referenced standards of the Sustainability Accounting Standards Board (now known as the Value Reporting Foundation), 66 per cent referenced the GRI’s guidelines for ESG reporting, and 48 per cent referenced recommendations of the TCFD. Private companies also reference these and other voluntary disclosure frameworks. The IRIS+ System, a framework for reporting on social and environmental performance, is used by impact investors to measure impact.
The two leading proxy advisory firms in the US, ISS and Glass Lewis, play an influential role in shaping corporate disclosures. These firms specialise in providing proxy voting recommendations to institutional investors and also rate companies on their governance, social and environmental disclosures. Since these regimes influence the proxy voting policies of institutional investors, their policies influence companies’ policies and disclosures.
What ratings, indices and guidelines are used to benchmark adherence to ESG principles and other non-financial factors in your jurisdiction?
Raters for public companies include the MSCI ESG Ratings, S&P Dow Jones Indices ESG Scores, Refinitiv ESG Scores, Sustainalytics, Morningstar, Bloomberg ESG data service, R-Factor, Moody’s ESG Solutions, FTSE Russell ESG ratings, and CDP. ISS QualityScore and ISS Environmental & Social Disclosure QualityScore also issue scores pertaining to ESG performance and disclosure. In the private investments space, the Global Impact Investing Rating System (GIIRS) and the IMP+ACT Classification System are used to assess the social and environmental impact of companies and funds. Indices for public companies include MSCI ESG Select Index, MSCI KLD 400 Social Index, Dow Jones Sustainability World Index, the S&P 500 Environmental & Socially Responsible Index, Thomson Reuters Global ESG Equal Weighted Index and FTSE4Good indexes. The proxy voting policies of ISS and Glass Lewis, and the scoring methodologies of ISS QualityScore and ISS Environmental & Social Disclosure Quality Score, are among the bases used to benchmark ESG performance and disclosure.
Are any fiscal incentives or other benefits available in your jurisdiction to encourage institutional investors and financial intermediaries to integrate ESG and other non-financial factors into their investment decision-making?
The tax-exempt status under the Internal Revenue Code (IRC) of program-related investments (PRIs) and mission-related investments (MRIs) is an example of direct tax incentives for private foundations that incorporate non-financial factors into their investment decision-making. Qualifying PRIs are not subject to jeopardising investment rules and are treated as taxable expenditures or subject to the excess business holding rules (so that a foundation will not be assessed an excise tax on the investment’s value). MRIs, investments with the dual purpose of generating income and furthering a foundation’s purpose, do not provide as many benefits as PRIs but may be exempt from jeopardising investment rules. IRS guidance provides that foundation managers may make investments that further a private foundation’s charitable purpose, even if the investment provides a lower return, as long as the managers exercise ordinary business care and prudence in making the investment decision.
Other fiscal incentives for purpose-driven companies provide indirect incentives to institutional investors. For example, regulations under the US Tax Cuts and Jobs Act provide tax incentives for investments in economically distressed communities. These incentives permit taxpayers to defer and reduce any capital gain they recognise provided that the amount of gain recognised is timely invested in certain funds that in turn invest in such communities and also exempt from tax all appreciation in the value of the taxpayer’s interests in such funds if they are held for at least 10 years.
Business organisation laws of states also create incentives through corporate forms, such as benefit corporations (allowed in 40 states), social purpose corporations (allowed in four states), low-profit limited liability companies (allowed in eight states), and benefit limited liability companies (allowed in five states).
In addition to ESG factors, what considerations and practices are commonly integrated into impact investment strategies?
Investors are increasingly enthusiastic about seeking impact and profit as complimentary objectives. Many are utilising traditional profit-seeking methods as a means to drive impact, for instance, by investing into proven and scalable business models. Impact strategies are focusing on integrating ESG-oriented practices into every stage of the investment cycle, from the original conception of a fund to forming and training a fund management team, obtaining appropriate outside advisers, innovative financing (for instance, blended finance), screening and due diligence, drafting terms in fund and investment agreements, incentivising employees of the portfolio company to optimise impact, ensuring a diverse portfolio company board and a diverse and inclusive workforce, monitoring and measuring impact performance at the portfolio level, and best practices for exiting investments.
On the public investment side, investment managers implement negative screening criteria (for instance, not investing in certain industries) or proactively invest in companies and funds with ESG-oriented themes. Institutional investors are increasingly pressuring publicly traded companies (for example, through bringing or supporting shareholder proposals, engagement and letters to portfolio companies) to enhance their environmental and social disclosures so that investors can rate, rank, and select investment opportunities using increasingly granular data.
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At a glance: ESG and investing in USA – Lexology
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